K E Y C O N C E P T S

Stock Market Basics

Firms raise some financial capital by selling stock(tradable security indicating partial ownership).

◆ Value of stock = equity capital.

◆ Dividend is a share of profits, paid in proportionto stock holdings.

Sales of stock from one individual to another arecarried out on a stock exchange.

◆ Stock price = price one share trades for on anexchange.

◆ Return = stock’s dividend + capital gain (increasein price) or – capital loss.

◆ Dividend yield = dividend as a percent of price;rate of return = return as percent of price.

◆ A firm’s accounting profits are its earnings.

• Price-earnings ratio = price/current earnings.

Stock price indexes such as the S&P Composite Indexor the Dow Jones Industrial Average track averagestock prices.

◆ In real terms, stock price indexes have risen onaverage over long time periods, but with manystrong fluctuations.

◆ One of the biggest increases in stock pricesoccurred in the late 1990s.

◆ Price-earnings ratios fluctuate lots too, with recentstrong increases.

How Are Stock Prices Determined?

The market fundamentals theory argues that theamount people are willing to pay for a stock is basedon the sources of value of that stock.

◆ Average willingness to pay depends on futureexpected dividend.

◆ People dislike uncertainty, and will pay less for astock with an uncertain rate of return.

• In such cases, people discount the uncertainfuture amount by the discount factor.

◆ The price of a stock will move towards the averagewillingness to pay by demand and supplypressures.

◆ Result: price = expected value of [discount factor ×(dividend + future price)].

◆ Forecast of future price is a rational expectation(uses all available information).

◆ Given that future price depends on futuredividends, market fundamentals price dependsonly on the stream of expected future dividendpayments.

An alternative theory is that of speculative bubbles—prices rise and fall sharply based on people expectingthem to rise and fall.

◆ Bubbles occur as people try and forecast eachothers’ forecasts, leading to herdlike behaviour.

◆ Some economists believe the late 1990s stockmarket boom was a bubble, others think thatmarket fundamentals had changed—true answer isstill not known.

C h a p t e r 35Global StockMarkets

Risk and Return

Stock prices fluctuate in an unpredictable or riskymanner, and some stocks fluctuate more than others.

◆ Investors will not hold riskier stocks unless theyare compensated by an additional return known asthe risk premium—riskier stocks generally havehigher rates of return.

◆ People have a higher discount rate for riskier stock,yielding a lower current price (expected dividendand future price held constant), and therefore ahigher expected rate of return.

◆ Risk can be reduced by portfolio diversification—holding a number of different stocks.

The Stock Market and the Economy

Over time, real stock earnings have trended upwards,although with lots of fluctuations.

◆ Stronger-than-usual growths in real stock earningsin 1890s, 1950s/1960s, and the 1990s.

◆ Each period involved the spread of newtechnologies.

◆ It is not clear yet if the 1990s involved the spreadof a “new economy” based on the spread of theInternet.

Monetary policy affects interest rates, which in turnaffect the stock market.

◆ Higher interests rates lead to lower stock pricesbecause they create:

• higher saving and lower spending on goods andservices and lower revenue for firms.

• higher returns on bonds, so some people switchfrom stocks to bonds.

◆ It is profitable for people to try and anticipatepolicy changes—if interest rates are expected torise, stock prices will fall before they rise.

Higher capital gains taxes lower the realized capitalgain people make by selling stocks at a higher price, sothey lower the demand for stocks and the price.

◆ Higher taxes on corporate profits also lower stockprices.

Rising stock prices lead to a rise in wealth (the marketvalue of assets).

◆ Via the wealth effect, consumption increases andthe saving rate (saving as a percent of disposableincome) decreases.

◆ The rising stock prices of the late 1990s primarilyaffected the wealth of those earning $100,000 ormore.

H E L P F U L H I N T S

1 One part of the stock market that sometimesconfuses students is the difference between theprimary market and the secondary market.

The primary market involves the initial saleof newly issued stock by a firm to investors. Atthat stage, the firm can use the money earnedfor the reason they raised it, typically investmentin new technology or physical capital, or toexpand markets.

The secondary market is the resale market ofthe above primary issues, the market in alreadyexisting stocks. Transactions in the stock marketare typically the secondary kind, involving tradesfrom one person to another, without involvingthe original firm in the transaction.

2 The price of a stock is determined by demandand supply. Specifically, on any given day, someholders of the stock will be trying to sell it, andsome others will be trying to buy it. Theinteraction of supply and demand (aided by thestock exchange in matching buyers and sellers)will determine the price at any given moment,and the size of the volume of sales.

We can use these concepts of demand andsupply to help us understand the various factorsthat create different prices for stocks. As anexample, suppose people find out that stock incompany A is riskier than they previouslythought. Holding constant the current price,expected future price, and expected futuredividends, this stock is now less desirable. As aresult, the demand for the stock decreases, andtherefore the price will decrease as well. With thelower current price, the expected capital gain (=expected future price – current price) is higher.Given this, the rate of return (= (expecteddividend + expected capital gain)/current price)must be higher. There is now a risk premiumincluded in the rate of return.

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S E L F - T E S T

True/False and Explain

Stock Market Basics

1 A dividend is the expected change in the price ofa stock.

2 Glitzsoft shares paid a dividend of $10 per sharelast year, and the stock rose in value from $20per share to $25 per share. The rate of returnwas 60%.

3 If a stock price is expected to increase over thenext year, the expected return will be higher.

4 Over the last 50 years, price-earnings ratios forthe S&P/TSX index have risen steadily.

5 Sales of stock from one individual to another arecarried out on a stock index.

How Are Stock Prices Determined?

6 In the market fundamentals view, people arewilling to pay for a stock based on the sources ofvalue of that stock.

7 In the market fundamentals view, the price of astock fundamentally depends only on the streamof expected future dividend payments.

8 People will pay less for a stock with moreuncertainty.

9 In the speculative bubbles view, if stock pricesrise, it is because people expected them to rise.

Risk and Return

10 The riskier the stock, the lower its current price(expected dividend and future price heldconstant), and the higher its expected rate ofreturn.

11 Risk can be reduced by holding a number ofdifferent stocks.

The Stock Market and the Economy

12 Strong than usual growths in real stock earningsare usually in periods that involve the spread ofnew technologies.

13 Higher interest rates raise stock prices.

14 Higher corporate taxes will lower stock prices.

15 Rising stock prices can lead to a decrease in thesaving rate.

Multiple-Choice

Stock Market Basics

1 Stock isa a tradable security that a firm issues to certify

the stockholder owns a share in the firm.b a proportional share of profits.c an entitlement to be paid first before any debtors

of the firm.d not related to the right to vote in the selection of

the firm’s directors.e an organized market where people buy and sell

shares.

G L O B A L S T O C K M A R K E T S 249

2 Table 35.1 below shows some information onthe earnings, dividend payments and stock priceson a yearly basis for Glitzsoft stock. What is thecapital gain on Glitzsoft stock between 1999 and2000?

a $10.00b $90.00c $100.00d –$10.00e –$12.00

TA B L E 35.1 G L I T Z S O F T S TO C K

Year Earnings Dividend StockEnding per Share Payments Price

1999 $10.00 $5.00 $100.00

2000 $5.00 $3.00 $90.00

3 Table 35.1 above shows some information onthe dividend payments and stock prices on ayearly basis for Glitzsoft stock. In 2000, whatwas the return on Glitzsoft Stock?

a $3.00b $7.00c $90.00d –$7.00e –$10.00

4 Table 35.1 above shows some information onthe earnings, dividend payments and stock priceson a yearly basis for Glitzsoft stock. What is therate of return on Glitzsoft stock in 2000?

a 12%b 13.33%c –7%d –10%e –12%

5 Table 35.1 above shows some information onthe earnings, dividend payments and stock priceson a yearly basis for Glitzsoft stock. What is thedividend yield on Glitzsoft stock in 2000?

a 60%b 5.55%c 3.33%d 3%e –3.33%

6 Table 35.1 above shows some information onthe earnings, dividend payments and stock priceson a yearly basis for Glitzsoft stock. What is theprice-earnings ratio on Glitzsoft stock in 2000?

a 0.033b 0.055c 18d 20e 30

7 Which of the following statements about stockmarket indexes is false?

a Real stock prices have had a positive trend overthe last 50 years.

b Real stock prices tend to move smoothlyupwards or downwards.

c Stock prices boomed in the 1990s.d U.S. stock prices climbed more than Canadian

stock prices in the 1990s.e Stock prices crashed at the start of the Great

Depression.

8 Which of the following indexes has the broadestset of stock prices in it?

a the Dow Jones Industrial Averageb the NASDAQc the FTSE 100d the S&P Composite Indexe the New York Stock Exchange Index

9 Which of the following statements about stockmarkets is correct?

a When a company goes bankrupt, only itscommon stockholders must pay its debt.

b When a company goes bankrupt, only itspreferred stockholders must pay its debt.

c Companies distribute all of their earnings asdividends.

d When you buy a share of Bombardier stock,Bombardier receives the funds.

e If a stock decreases in price after you buy it, youhave a capital loss on the stock.

250 C H A P T E R 3 5

How Are Stock Prices Determined?

10 Which of the following quotations is consistentwith the market fundamentals view of stockprices?

a “Since Glitzsoft is paying such good dividendsnow and in the future, I think it is a good buy.”

b “Since Glitzsoft’s future dividends stream is souncertain, I think it is a good buy.”

c “Since everyone else in the market seems tothink Glitzsoft’s stock price will rise, I am notgoing to buy it.”

d “Since everyone else in the market seems tothink Glitzsoft’s stock price will rise, I am goingto buy it.”

e “I think that Glitzsoft stock will rise in valuenext year, so I am not going to buy now, sincethe dividend payments are low.”

11 Which of the following quotations is consistentwith the speculative bubbles view of stockprices?

a “Since Glitzsoft is paying such good dividendsnow and in the future, I think it is a good buy.”

b “Since Glitzsoft’s future dividends stream is souncertain, I think it is a good buy.”

c “Since everyone else in the market seems tothink Glitzsoft’s stock price will rise, I am notgoing to buy it.”

d “Since everyone else in the market seems tothink Glitzsoft’s stock price will rise, I am goingto buy it.”

e “I think that Glitzsoft stock will rise in valuenext year, so I am not going to buy some now,since the dividend payments are low.”

12 You are considering buying a share of stock. Thecompany is expected to earn $40 per share nextyear, but is expected to only pay a dividend of$20. You expect the value of the share to be$100 next year. Your discount factor is 0.75.What is the most you will be willing to pay forthe share?

a $120b $105c $100d $90e $75

13 If news comes out that the IPSCO SteelCompany unexpectedly failed to get the contractto manufacture the pipeline for the AlaskanPipeline starting in 3 years, which of thefollowing statements describes what will happenaccording to the market fundamentals view?

a Nothing will happen.b The price of IPSCO stock will fall in 3 years.c The price of IPSCO stock will fall in 2 years.d The price of IPSCO stock will fall immediately.e The price of IPSCO stock will rise now, so that

it can fall in 3 years.

14 Which of the following activities most closelyresembles stock-picking decisions in thespeculative bubble view?

a Trying to decide which person is going to bevoted off the island by the other people.

b Deciding which person to vote off the island.c Carefully calculating which person has the best

survival skills on the island.d Checking out the TV Guide to find out when

the next episode comes on.e Eating bugs to get immunity.

15 Which of the following statements best describeswhy people discount future payments?

a People prefer current consumption to futureconsumption and they discount uncertain futurepayments.

b People prefer future consumption to currentconsumption and they discount uncertain futurepayments.

c People prefer current consumption to futureconsumption and they discount stock marketbubbles.

d People prefer future consumption to currentconsumption and they discount stock marketbubbles.

e Rational expectations require them to discountthe future.

G L O B A L S T O C K M A R K E T S 251

Risk and Return

16 What happens if people discover that a stock’sprices are going to fluctuate even more thanusual in the future?

a People discount the stock more, leading to alower current price and a higher expected return.

b People discount the stock less, leading to a lowercurrent price and a higher expected return.

c People discount the stock more, leading to ahigher current price and a higher expectedreturn.

d People discount the stock more, leading to alower current price and a lower expected return.

e People discount the stock less, leading to ahigher current price and a lower expected return.

17 What is the cost of using portfoliodiversification?

a Your risk goes up.b You are more likely to get caught in a speculative

bubble.c You are ignoring market fundamentals, and will

likely earn a negative return.d You expected return is lower.e You must borrow to carry out the diversification.

18 Which of the following statements about stockmarket risk is false?

a Portfolio diversification reduces risk.b People discount riskier stocks more.c Riskier stocks usually pay a risk premium.d Riskier stocks usually sell for a higher price.e People will accept lower expected returns to

avoid risk.

The Stock Market and the Economy

19 Which of the following statements best describesthe timepath of real stock earnings in the last140 years?

a Real stock earnings had no distinct upward ordownward trend, but fluctuate a lot.

b Real stock earnings had no distinct upward ordownward trend, except for burst of highearnings growth in the 1890s, 1950s/1960s and1990s.

c Real stock earnings had a distinct upward trend,with lots of fluctuations.

d Real stock earnings had a distinct upward trend,with almost no fluctuations.

e Real stock earnings had a distinct downwardtrend, with lots of fluctuations.

20 Which of the following does not affect real stockearnings?

a New technologies.b Taxes.c Interest rates.d Monetary policy.e Inflation.

21 Which of the following best describes howinterest rates affect stock prices?

a Higher interest rates mean more risk, andtherefore lead to lower stock prices.

b Higher interest rates encourage stockholders tobuy more shares, seeking the higher returns.

c Higher interest rates make borrowing moreexpensive, and this leads to less spending andlower earnings for firms.

d Higher interest rates encourage bondholders toswitch to stocks.

e Higher interest rates raise wealth, and thereforeencourage people to buy fewer shares.

22 Which of the following best describes how taxesaffect stock prices?

a Taxes make stocks riskier, and therefore lead tolower stock prices.

b Taxes reduce firms’ earnings, and lead to lowerstock prices.

c Taxes increase capital gains, and lead to higherstock prices.

d Taxes reduce capital gains, and lead to higherstock returns and higher stock prices.

e Taxes reduce the number of transactions, andtherefore reduce the demand for stocks.

23 How do investors profit by anticipating thecentral bank’s monetary policy?

a If they expect expansionary monetary policy,they will sell stocks before the stock prices fall.

b If they expect expansionary monetary policy,they will buy stock before the stock prices rise.

c If they expect contractionary monetary policy,they will buy stock before the stock prices rise.

d If they expect contractionary monetary policy,they will sell stock before the stock prices rise.

e If they expect an increase in taxes, they will buystock before the stock prices rise.

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24 Why do increases in the value of the stockmarket lead to a lower saving rate?

a With more wealth, people wish to buy morestocks, and take the money out of their savings.

b With more wealth, people spend less, leading tolower saving.

c With more wealth, people are less worried aboutrisk, and spend more on stocks and save less.

d With more wealth, people spend more onconsumption, and save less.

e With more wealth, firms find their earningsincreasing, and save less.

25 Which of the following statements is correct?1 During the 1990s, the saving rate excluding

capital gains decreased in Canada.2 During the 1990s, the saving rate including

capital gains increased in Canada.a 1 only.b 2 only.c Both 1 and 2.d Neither 1 nor 2.e 1 is true, 2 is not measurable.

Short Answer Problems

1 Consider the information in Table 35.2 onGlitzsoft Stock.

a Fill in the remainder of the table. b Why did Glitzsoft still pay a dividend, even

when its earnings were negative?c Why did investors still keep the stock price high

in 2001, when Glitzsoft had negative earnings?

2 Explain how and why riskier stocks pay higherexpected returns.

3 The stock market rose dramatically in value inCanada and especially in the United States inthe 1990s. Do you think this was due to aspeculative bubble, or to a change in marketfundamentals due to the introduction of newtechnologies. Explain your reasoning briefly.

4 Morgan’s discount rate is 0.8. Lubaba’s discountrate is 0.75. They are each considering buyingthe stocks listed in Table 35.3 below, which alsoshows each person’s evaluation of the expecteddividend and price of the stock. Each stock sellsfor $100 per share. Explain whether or not theywill buy each stock, and explain why you know.

TA B L E 35.3 S TO C K D I V I D E N D A N DF U T U R E P R I C E E S T I M AT E S

Bobbie’s Dolls’n’Toys Maxwell’s MP3 Mart

Estimated EstimatedEstimated Future Estimated FutureDividend Price Dividend Price

Morgan $10 $120 $4 $110

Lubaba $12 $125 $2 $140

5 With respect to your answers to Short AnswerProblem 4, how would your answers change ifyou found out Morgan and Lubaba lived in aprovince with a capital gains tax?

6 Microsoft announced in January of 2003 that itwould pay a dividend. It has never paid adividend before then. Why would people wantto hold a stock that pays no dividend?

7 According to the market fundamentals view, theprice of a stock depends only on the stream ofexpected future dividend payments. Explainbriefly why.

8 When James Tobin won the Nobel Prize inEconomics, he was asked to explain in simplewords the theory of risk diversification that wonhim the Nobel Prize. His answer “Don’t put allyour eggs in one basket.” In terms of buyingstocks, why shouldn’t you put all your eggs inone basket?

9 Your granny maintains a large portfolio ofstocks. She has heard that she should befollowing monetary policy in order to properly

G L O B A L S T O C K M A R K E T S 253

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TA B L E 35.2 GL ITZSOFT STOCK

Year Earnings Dividend Stock Price-Earnings Dividend Rate ofEnding per Share Payments Price Ratio Yield Return

1999 $8.00 $4.00 $100.00 —

2000 $5.00 $3.00 $90.00

2001 –$5.00 $7.00 $100.00

2002 $12.00 $10.00 $110.00

look after her portfolio. She would like you toexplain why she should follow monetary policy.

10 Why did the measured saving rate (excludingcapital gains) collapse in Canada and the UnitedStates in the late 1990s?

A N S W E R S

True/False and Explain

1 F It is a share of profits. (831)2 F 75% = (10 + (25 – 20))/20 × 100. (831)3 T Expected return = expected dividend +

expected capital gain. (831)4 F They have risen, but with many fluctuations

up and down. (832–833)5 F Carried out on a stock market. (830–832)6 T Definition. (836–837)7 T Individuals look at the expected value of the

discounted dividend and future price, andsince the future price depends on futuredividends, then they are really looking only atthe stream of expected future dividends.(838)

8 T People dislike uncertainty, so their willingnessto pay is lower. (836–838)

9 T Defined by self-fulfilling expectations.(838–839)

10 T Riskier stock means lower demand, whichleads to a lower price holding constant futureprice, which means a higher expected capitalgain and higher expected return. (840)

11 T Portfolio diversification reduces range ofpossible outcomes. (840)

12 T See text discussion. (841–842)13 F Higher interest rates lead to lower spending

by consumers, lower earnings by firms, lowerstock prices. (842–843)

14 T Higher taxes mean lower net earnings forfirms, lower return for stockholders, lowerdemand for stock. (843)

15 T Capital gains mean rising wealth, and lessneed to save. (843–845)

Multiple-Choice

1 a Definition. (830)2 d Change in price. (831)3 d Dividend – capital loss. (831)4 c Return as a percent of 1999 price. (831)5 c Dividend as a percent of 2000 price. (831)6 c 90/5. (831)7 b They fluctuate a great deal. (832–835)

8 d See text discussion. (832–833)9 e Stockholders have limited liability, companies

frequently reinvest earnings, and Bombardieronly gets the sale price for the initial sale.(830–835)

10 a b is nonsense, c or d would be speculativebubble views, and e is wrong, might buy.(838–838)

11 d Herd behaviour. (838–839)12 d Willingness to pay = 0.75 × ($20 + $100).

(836–838)13 d Since future earnings/dividends expected to

be lower, current willingness to pay falls,current price falls. (836–838)

14 a Trying to pick who other people think is awinning stock, as opposed to picking the beststock. (838–839)

15 a See text discussion. (836)16 a React to extra uncertainty by increasing

discount rate, lowering willingness to pay andcurrent price, raising expected returns. (840)

17 d See text discussion. (840)18 d Sell for lower price. (840)19 c See Text Figure 35.6. (841)20 e Real earnings control for inflation effects.

(841–845)21 c Lower earnings for firms means lower

dividends, and lower willingness to pay, lowerprice. (842–843)

22 b Taxes do lower capital gains, but this leads tolower current stock prices. (843)

23 b Expansionary policy will lead to lower interestrates, higher stock prices in the future.(842–843)

24 d Capital gains are part of wealth, and spendingdepends on wealth. (843–845)

25 a See text discussion around Text Figures 35.7and 35.8. (844–845)

Short Answer Problems

1 a Table 35.2 is filled in on the next page asTable 35.2 Solution.

b It paid a dividend to keep its stockholdershappy, and to keep them holding the stock.

c The investors were expecting that the futurestream of earnings would be positive.

2 Investors do not like risk, so they will show alower willingness to pay, by discounting a riskierstock by more than a less risky stock with thesame expected dividend payments and futureprice. This extra discounting will mean a lowercurrent price for the stock. Since the currentprice is lower, but the future expected price isthe same, the riskier stock will pay an higherexpected capital gain and higher expected return.

254 C H A P T E R 3 5

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3 Any answer to this question is a valuejudgement, but should be based on anargument. In favour of the speculative bubblesview, we see a strong rise and decline in stockprices, the strongest rise in history, out ofproportion to the changes in earnings. In favourof the market fundamentals view, we see thatearnings were strong in the 1990s, and we seethere was an unusual technological revolutiongoing on, just as in previous situations wherestocks rose sharply. The big unresolved questionis whether or not the earnings rise is strong andpermanent enough to justify the higher prices.

4 Each person will calculate their willingness topay based on the formula:

P1 = expected value of [discount rate ×(dividend + future price)]

For Morgan, Bobbie’s Dolls’n’Toys is worth$104 = 0.8 x [$10 + $120] to her. Maxwell’s isworth $91.20 = 0.8 × [$4 + $110] to her. Shewill buy a share of Bobbie’s, but not of Maxwell’sstock.

For Lubaba, Bobbie’s Dolls’n’Toys is worth$102.75 = 0.75 × [$12 + $125] to her.Maxwell’s is worth $106.50 = 0.75 × [$2 +$140] to her. She will buy a share of both stocks.

5 If either person has to pay capital gains taxes, wewould have to use the after-tax value of thecapital gain in our calculations, and this wouldreduce the potential return on any stock.Morgan and Lubaba would not start buying oneof the stocks they have already rejected, and theymay reject buying one of those they haveaccepted, if the tax rate is high enough to reducethe willingness to pay below $100.

6 The investors anticipated that future earnings orfuture capital gains would give them the returnthey are looking for.

7 Individuals prefer current consumption to futureconsumption, and they dislike uncertainty. Forthese two reasons, they discount future payments.Buying a stock entitles you to a share of futuredividends, and to the right to sell the stock in the

future. Combining discounting, dividends andthe right to sell, we can logically see that

P1 = expected value of [discount rate ×(dividend + future price)]

The expected future price, by logic, will alsodepend on the expected future dividend.Substituting in all these expected future pricestells us that the current price will depend on thestream of expected future payments.

8 Putting all your eggs in one basket (investingeverything in one stock) is riskier than holding amixture of stocks in your portfolio—portfoliodiversification. Holding the mixture of stocksmeans that the actual potential range of yourearnings is smaller then if you held only onetype of stock.

9 Monetary policy affects interest rates, which inturn affect stock prices. For example, if interestrates fall in value, then stock prices will beaffected via two routes. First, the lower interestrates will encourage more borrowing (and lesssaving) and more spending by consumers andbusiness, which in turn will lead to moreearnings for firms, and higher future dividends.As a result, the expected return on stocks ishigher, and your granny should buy more.

Secondly, the lower interest rates will lowerthe return on stocks, and individuals (includingyour granny) will switch from bonds to stocks.This increase in demand will also increase theprice of stocks, so your granny might like toanticipate this increase by buying stocks now.

10 The strong rise in the value of stock markets inCanada and the United States added to the wealthof households—the change in wealth was positivedue to the paper capital gains they earned. As aresult of the higher wealth, households spentmore and saved less out of their currentdisposable income—the saving rate plummeted.

Another way to think of this is to note thattheir savings rate including capital gains did notplummet—they did indeed save (accumulatewealth).

G L O B A L S T O C K M A R K E T S 255

TA B L E 35.2 GL ITZSOFT STOCK

Year Earnings Dividend Stock Price-Earnings Dividend Rate ofEnding per Share Payments Price Ratio Yield Return

1999 $8.00 $4.00 $100.00 12.5 4% —

2000 $5.00 $3.00 $90.00 18 3.33% –7%

2001 –$5.00 $7.00 $100.00 — 7% 18.9%

2002 $12.00 $10.00 $110.00 9.17 9.1% 20%

P R O B L E M

You are an advisor to the prime minister,specializing in exchange rate considerations. TheCanadian dollar is suffering from a crisis ofnonconfidence on world markets, sparked by aneconomic crisis in Asia. Foreign investors areafraid that Canada’s economy will be hurt by theAsian economic crisis, since Asia buys manycommodities from Canada. The investors areafraid that profits and returns at Canadiancompanies will decrease dramatically. Foreignersstart a selloff of Canadian assets.

a Explain to the prime minister (with the aid of agraph showing the demand and supply of dollars)what this will imply for the value of the Canadiandollar, as well as for interest rates, the value of themonetary base and the money supply, and thethree balance of payments accounts. (The Bank ofCanada is operating under a rule of trying tostabilize the exchange rate.)

b Another advisor to the prime minister has toldher that the Bank of Canada should be orderedto increase the money supply to try and lowerinterest rates. What will this do to the value ofthe exchange rate and to foreign holdings ofCanadian assets? Can the Bank of Canada dothis and still maintain a managed exchange rate?

c The prime minister has received a phone callfrom the owner of Big Importer Company,complaining that the change in the value of theCanadian dollar has hurt his ability to sellimported whatzits in Canada. With the aid of agraph of the market for whatzits in Canada(with the vertical axis measuring the price ofwhatzits in Canadian dollars), explain to theprime minister what has happened to the priceand quantity imported in this market. What hashappened to exports? to the balance of trade?

d The prime minister has been considering askingthe Bank of Canada to defend the dollar morestrongly, but is worried about the impact on thestock market. Briefly explain to her the impactof defending the Canadian dollar on the stockmarket.

e The prime minister asks you whether she shouldask the Bank of Canada to defend the dollareven more strongly, or not. What do you think?

M I D T E R M E X A M I N A T I O N

You should allocate 24 minutes for this examination(12 questions, 2 minutes per question). For eachquestion, choose the one best answer.

1 The short-run adjustment costs in Canadaassociated with reducing the level of tariffs undera North American Free Trade Agreement will beborne principally by

a taxpayers, whose higher taxes provide thegenerous retraining programs.

b employers and workers in those sectors in whichCanada has a comparative advantage.

c employers and workers in those sectors in whichCanada has a comparative disadvantage.

d Canadian consumers of imported goods.e Canadian producers of exported goods.

2 Table P10.1 below shows some information onthe dividend payments and stock prices on ayearly basis for Present Shop Inc. What is thecapital gain on Present Shop stock between 2001and 2002?

a $20.00b $32.00c $45.00d –$20.00e $0.00

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P a r t 1 0 W r a p U p

C h a p t e r s

33–35Understanding theGlobal Economy

TA B L E P10.1 P R E S E N T S H O P S TO C K

Year Earnings Dividend StockEnding per Share Payments Price

2001 $15.00 $12.00 $125.00

2002 $20.00 $12.00 $145.00

3 Which of the following quotations best describesthe interest rate parity effect?

a “The recent high Canadian interest rate hasincreased the demand for the Canadian dollar.”

b “The market feeling is that the Canadian dollaris overvalued and will likely appreciate.”

c “The price of bananas is the same in Canada andthe United States, adjusting for the exchangerate.”

d “The expected appreciation of the Canadiandollar is currently lowering demand for it.”

e None of the above.

4 Which of the following statements with regardto stock market risk is true?

a Portfolio diversification increases risk.b People discount riskier stocks less.c Riskier stocks usually pay a risk premium.d Riskier stocks usually sell for a higher price.e People need lower expected returns to accept

risk.

5 Atlantis imports watches from Beltran andexports widgets to Beltran. Why would Atlantisprefer arranging a voluntary export restraintrather than a quota on watches?

a to not hurt Beltran’s importsb to prevent Beltran from retaliating by restricting

Atlantis’ exportsc to keep the domestic price of watches lowd to increase government revenuee to help domestic producers

6 Which of the following would cause the dollarto depreciate against the yen?

a an increase in the Canadian monetary supplyb an increase in interest rates in Canadac a decrease in interest rates in Japand an increase in the expected future exchange ratee a decrease in the current exchange rate

7 You are considering buying a share of stock. Thecompany is expected to earn $50 per share nextyear, but is expected to only pay a dividend of$25. You expect the value of the share to be$200 next year. Your discount factor is 0.8.What is the most you will be willing to pay forthe share?

a $250b $225c $200d $180e $160

8 If Fullofland is currently a net lender and adebtor nation,

a it has loaned more capital than it borrowedabroad this year, but borrowed more than itloaned during its history.

b it has borrowed more capital than it loanedabroad this year and also borrowed more than itloaned during its history.

c it has loaned more capital than it borrowedabroad this year and has loaned more than itborrowed during its history.

d its accounting system must be in error if it showsthis nation to be a net lender and a debtornation at the same time.

e its debts must be currently growing.

9 Suppose Musicland and Videoland produce twogoods—CDs and videos. Musicland has acomparative advantage in the production ofCDs if

a fewer CDs must be given up to produce oneunit of videos than in Videoland.

b less labour is required to produce one unit ofCDs than in Videoland.

c less capital is required to produce one unit ofCDs than in Videoland.

d less labour and capital are required to produceone unit of CDs than in Videoland.

e fewer videos must be given up to produce oneunit of CDs than in Videoland.

10 Which of the following changes is likely toincrease real stock earnings?

a Introduction of new technologies.b Higher corporate profits taxes.c Higher interest rates.d Contractionary monetary policy.e Higher capital gains taxes.

U N D E R S T A N D I N G T H E G L O B A L E C O N O M Y 257

11 Acadia and Breton are currently engaged in freetrade. Acadia imports cheese from Breton andexports sheep to Breton. If Acadia imposes atariff on cheese, Acadia’s cheese-producingindustry will

a expand, and its sheep-producing industry willcontract.

b expand, and its sheep-producing industry willexpand.

c contract, and its sheep-producing industry willcontract.

d contract, and its sheep-producing industry willexpand.

e expand, and its sheep-producing industry will beunchanged.

12 Canada has a trade deficit when thea value of Canadian exports of goods and services

exceeds the value of Canadian imports of goodsand services.

b value of Canadian exports of goods and servicesis exceeded by the value of Canadian imports ofgoods and services.

c value of Canadian exports of goods exceeds thevalue of Canadian imports of goods.

d value of Canadian exports of goods is exceededby the value of Canadian imports of goods.

e current account balance is less than zero.

A N S W E R S

Problem

a The fear of lower future returns leads to adecrease in the demand for Canadian dollarassets, leading to a decrease in the demand forCanadian dollars. In Figure P10.1, this decrease,in turn, leads to a decrease in the value of theexchange rate from Fa to Fb. To keep it fromdecreasing even further, the Bank of Canadaintervenes and buys Canadian dollars, supplyingforeign exchange from official reserves. They alsomight shrink the money supply, which will tendto increase Canadian interest rates. (There arealso potential supply effects not shown here.)

Foreigners are lending us less, so the capitalaccount will move towards a smaller surplus or adeficit. The decrease in the foreign exchange valueof the Canadian dollar will lead to an increase inexports and a decrease in imports (see part cbelow), so that the current account will movetowards a surplus. Since the Bank of Canada issupplying foreign exchange, this is a decrease inreserves, or a movement towards a surplus.

F I G U R E P10.1

b A lower interest rate would spark a furtherdecrease in the demand for the Canadian dollar,as foreigners buy fewer Canadian assets, given thelower Canadian interest rate differential. Thiswould tend to push down the Canadian dollar’svalue, which would conflict with the Bank ofCanada’s attempts to stabilize the exchange rate.

c The market for whatzits is shown in FigureP10.2. The new, lower exchange rate of fewerU.S. dollars per Canadian dollar means moreCanadian dollars per U.S. dollar, and acts like atariff—it increases the Canadian dollar price ofthe imported whatzits, shown as the shiftleftward in the supply curve. This change leadsto a new equilibrium, with a higher price, and alower quantity imported and sold.

The market for Canadian exports would beacting in an opposite manner, with lower pricesand more exports. The higher exports and lowerimports will mean the balance of trade (and hencethe current account) is moving towards a surplus.

d Defending the Canadian dollar involvesshrinking the money supply, and raising interestrates. Higher interest rates lead to a) lessborrowing, less consumption and investmentexpenditure and less revenue earning by firms,and lower demand for stocks, as well as b) stockholders selling their stock and shifting to bonds.The net effect is lower stock prices.

e The answer is a value judgement, and dependson the value you place on defending theCanadian dollar (for example, helping theimporter) versus the damage the defense mightdo to the Canadian economy. Defending theCanadian dollar will entail buying Canadiandollars (which will shrink the domestic moneysupply), and raising Canadian interest rates.Both of these actions will depress aggregatedemand and put downward pressure on realGDP and jobs. It is your call.

258 P A R T 1 0 W R A P U P — C H A P T E R S 3 3 – 3 5

Quantity of Dollars

Fore

ign

Exch

ange

Valu

e of

the

Dol

lar

Fa

Fb

S

a

b

D0

D1

➡

ct

U N D E R S T A N D I N G T H E G L O B A L E C O N O M Y 259

F I G U R E P10.2

Midterm Examination

1 c Because decrease in U.S. or Mexican pricesimplies decrease in Canadian production.(802–803)

2 a Change in market price of stock. (831)3 a If two currencies do not have the same

interest rate, market conditions will changethe demand for assets and the dollar.(821–822)

4 c Because people do not like riskier stocks, theydiscount them more, leading to a lower price,and a higher return. (840)

5 b Under a VER, exporting country gains excessrevenue, which means it is less likely toretaliate, since hurt less. (794–796)

6 a a decreases interest rates, which decreasedemand for Canadian dollars. b–d areincrease in demand, e move along, not a shift.(820)

7 d Price = discount rate × (expected dividend +expected future price). (836–838)

8 a Definitions of net lender and debtor nation.Debts are shrinking. (812)

9 e Definition. (787–788)10 a It leads to higher earnings for firms.

(841–845)11 a Tariff increases domestic price of cheese,

which decreases imports, which increasesdomestic production. Decreased imports =decreased exports in Breton, which decreasesits income, which decreases its imports =decrease in Acadia’s exports, decreasingAcadia’s sheep production. (794–795)

12 b Definition of balance of trade. (810)

Thousands of Whatzits

Pric

e of

Wha

tzits

(Can

adia

n do

llars

)

Pa

Pb

a

b

Qb

New Foreign Export Supply

Canadian ImportDemand

Qa

➡

Original ForeignExport Supply