C h a p t e r
How Are Stock Prices Determined?
K E Y C O N C E P T S
The market fundamentals theory argues that the
Stock Market Basics amount people are willing to pay for a stock is based
on the sources of value of that stock.
Firms raise some financial capital by selling stock ◆ Average willingness to pay depends on future
(tradable security indicating partial ownership). expected dividend.
◆ Value of stock = equity capital. ◆ People dislike uncertainty, and will pay less for a
◆ Dividend is a share of profits, paid in proportion stock with an uncertain rate of return.
to stock holdings. • In such cases, people discount the uncertain
Sales of stock from one individual to another are future amount by the discount factor.
carried out on a stock exchange. ◆ The price of a stock will move towards the average
◆ Stock price = price one share trades for on an willingness to pay by demand and supply
◆ Return = stock’s dividend + capital gain (increase ◆ Result: price = expected value of [discount factor ×
in price) or – capital loss. (dividend + future price)].
◆ Dividend yield = dividend as a percent of price; ◆ Forecast of future price is a rational expectation
rate of return = return as percent of price. (uses all available information).
◆ A firm’s accounting profits are its earnings. ◆ Given that future price depends on future
dividends, market fundamentals price depends
• Price-earnings ratio = price/current earnings. only on the stream of expected future dividend
Stock price indexes such as the S&P Composite Index payments.
or the Dow Jones Industrial Average track average An alternative theory is that of speculative bubbles—
stock prices. prices rise and fall sharply based on people expecting
◆ In real terms, stock price indexes have risen on them to rise and fall.
average over long time periods, but with many ◆ Bubbles occur as people try and forecast each
strong fluctuations. others’ forecasts, leading to herdlike behaviour.
◆ One of the biggest increases in stock prices ◆ Some economists believe the late 1990s stock
occurred in the late 1990s. market boom was a bubble, others think that
◆ Price-earnings ratios fluctuate lots too, with recent market fundamentals had changed—true answer is
strong increases. still not known.
248 CHAPTER 35
Risk and Return
H E L P F U L H I N T S
Stock prices fluctuate in an unpredictable or risky
manner, and some stocks fluctuate more than others. 1 One part of the stock market that sometimes
◆ Investors will not hold riskier stocks unless they confuses students is the difference between the
are compensated by an additional return known as primary market and the secondary market.
the risk premium—riskier stocks generally have The primary market involves the initial sale
higher rates of return. of newly issued stock by a firm to investors. At
that stage, the firm can use the money earned
◆ People have a higher discount rate for riskier stock, for the reason they raised it, typically investment
yielding a lower current price (expected dividend in new technology or physical capital, or to
and future price held constant), and therefore a expand markets.
higher expected rate of return. The secondary market is the resale market of
◆ Risk can be reduced by portfolio diversification— the above primary issues, the market in already
holding a number of different stocks. existing stocks. Transactions in the stock market
are typically the secondary kind, involving trades
from one person to another, without involving
The Stock Market and the Economy the original firm in the transaction.
Over time, real stock earnings have trended upwards, 2 The price of a stock is determined by demand
although with lots of fluctuations. and supply. Specifically, on any given day, some
◆ Stronger-than-usual growths in real stock earnings holders of the stock will be trying to sell it, and
in 1890s, 1950s/1960s, and the 1990s. some others will be trying to buy it. The
interaction of supply and demand (aided by the
◆ Each period involved the spread of new stock exchange in matching buyers and sellers)
technologies. will determine the price at any given moment,
◆ It is not clear yet if the 1990s involved the spread and the size of the volume of sales.
of a “new economy” based on the spread of the We can use these concepts of demand and
Internet. supply to help us understand the various factors
that create different prices for stocks. As an
Monetary policy affects interest rates, which in turn example, suppose people find out that stock in
affect the stock market. company A is riskier than they previously
◆ Higher interests rates lead to lower stock prices thought. Holding constant the current price,
because they create: expected future price, and expected future
dividends, this stock is now less desirable. As a
• higher saving and lower spending on goods and result, the demand for the stock decreases, and
services and lower revenue for firms. therefore the price will decrease as well. With the
• higher returns on bonds, so some people switch lower current price, the expected capital gain (=
from stocks to bonds. expected future price – current price) is higher.
◆ It is profitable for people to try and anticipate Given this, the rate of return (= (expected
policy changes—if interest rates are expected to dividend + expected capital gain)/current price)
rise, stock prices will fall before they rise. must be higher. There is now a risk premium
included in the rate of return.
Higher capital gains taxes lower the realized capital
gain people make by selling stocks at a higher price, so
they lower the demand for stocks and the price.
◆ Higher taxes on corporate profits also lower stock
Rising stock prices lead to a rise in wealth (the market
value of assets).
◆ Via the wealth effect, consumption increases and
the saving rate (saving as a percent of disposable
◆ The rising stock prices of the late 1990s primarily
affected the wealth of those earning $100,000 or
G L O B A L S TO C K M A R K E T S 249
Risk and Return
S E L F - T E S T
10 The riskier the stock, the lower its current price
(expected dividend and future price held
True/False and Explain constant), and the higher its expected rate of
Stock Market Basics
1 A dividend is the expected change in the price of
11 Risk can be reduced by holding a number of
2 Glitzsoft shares paid a dividend of $10 per share
last year, and the stock rose in value from $20
per share to $25 per share. The rate of return The Stock Market and the Economy
12 Strong than usual growths in real stock earnings
are usually in periods that involve the spread of
3 If a stock price is expected to increase over the
next year, the expected return will be higher.
13 Higher interest rates raise stock prices.
4 Over the last 50 years, price-earnings ratios for
the S&P/TSX index have risen steadily.
14 Higher corporate taxes will lower stock prices.
5 Sales of stock from one individual to another are
carried out on a stock index. 15 Rising stock prices can lead to a decrease in the
How Are Stock Prices Determined?
6 In the market fundamentals view, people are
willing to pay for a stock based on the sources of Stock Market Basics
value of that stock.
1 Stock is
a a tradable security that a firm issues to certify
the stockholder owns a share in the firm.
7 In the market fundamentals view, the price of a b a proportional share of profits.
stock fundamentally depends only on the stream c an entitlement to be paid first before any debtors
of expected future dividend payments. 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
8 People will pay less for a stock with more shares.
9 In the speculative bubbles view, if stock prices
rise, it is because people expected them to rise.
250 CHAPTER 35
2 Table 35.1 below shows some information on 6 Table 35.1 above shows some information on
the earnings, dividend payments and stock prices the earnings, dividend payments and stock prices
on a yearly basis for Glitzsoft stock. What is the on a yearly basis for Glitzsoft stock. What is the
capital gain on Glitzsoft stock between 1999 and price-earnings ratio on Glitzsoft stock in 2000?
2000? a 0.033
a $10.00 b 0.055
b $90.00 c 18
c $100.00 d 20
d –$10.00 e 30
7 Which of the following statements about stock
TA B L E 35.1 G L I T Z S O F T S TO C K market indexes is false?
Year Earnings Dividend Stock
a Real stock prices have had a positive trend over
Ending per Share Payments Price the last 50 years.
b Real stock prices tend to move smoothly
1999 $10.00 $5.00 $100.00
upwards or downwards.
2000 $5.00 $3.00 $90.00
c Stock prices boomed in the 1990s.
d U.S. stock prices climbed more than Canadian
stock prices in the 1990s.
3 Table 35.1 above shows some information on e Stock prices crashed at the start of the Great
the dividend payments and stock prices on a Depression.
yearly basis for Glitzsoft stock. In 2000, what
was the return on Glitzsoft Stock? 8 Which of the following indexes has the broadest
a $3.00 set of stock prices in it?
b $7.00 a the Dow Jones Industrial Average
c $90.00 b the NASDAQ
d –$7.00 c the FTSE 100
e –$10.00 d the S&P Composite Index
e the New York Stock Exchange Index
4 Table 35.1 above shows some information on
the earnings, dividend payments and stock prices 9 Which of the following statements about stock
on a yearly basis for Glitzsoft stock. What is the markets is correct?
rate of return on Glitzsoft stock in 2000?
a When a company goes bankrupt, only its
a 12% common stockholders must pay its debt.
b 13.33% b When a company goes bankrupt, only its
c –7% preferred stockholders must pay its debt.
d –10% c Companies distribute all of their earnings as
e –12% dividends.
d When you buy a share of Bombardier stock,
5 Table 35.1 above shows some information on Bombardier receives the funds.
the earnings, dividend payments and stock prices e If a stock decreases in price after you buy it, you
on a yearly basis for Glitzsoft stock. What is the have a capital loss on the stock.
dividend yield on Glitzsoft stock in 2000?
G L O B A L S TO C K M A R K E T S 251
How Are Stock Prices Determined? 13 If news comes out that the IPSCO Steel
Company unexpectedly failed to get the contract
10 Which of the following quotations is consistent to manufacture the pipeline for the Alaskan
with the market fundamentals view of stock Pipeline starting in 3 years, which of the
prices? following statements describes what will happen
a “Since Glitzsoft is paying such good dividends according to the market fundamentals view?
now and in the future, I think it is a good buy.” a Nothing will happen.
b “Since Glitzsoft’s future dividends stream is so b The price of IPSCO stock will fall in 3 years.
uncertain, I think it is a good buy.” c The price of IPSCO stock will fall in 2 years.
c “Since everyone else in the market seems to d The price of IPSCO stock will fall immediately.
think Glitzsoft’s stock price will rise, I am not e The price of IPSCO stock will rise now, so that
going to buy it.” it can fall in 3 years.
d “Since everyone else in the market seems to
think Glitzsoft’s stock price will rise, I am going 14 Which of the following activities most closely
to buy it.” resembles stock-picking decisions in the
e “I think that Glitzsoft stock will rise in value speculative bubble view?
next year, so I am not going to buy now, since a Trying to decide which person is going to be
the dividend payments are low.” voted off the island by the other people.
b Deciding which person to vote off the island.
11 Which of the following quotations is consistent c Carefully calculating which person has the best
with the speculative bubbles view of stock survival skills on the island.
prices? d Checking out the TV Guide to find out when
a “Since Glitzsoft is paying such good dividends the next episode comes on.
now and in the future, I think it is a good buy.” e Eating bugs to get immunity.
b “Since Glitzsoft’s future dividends stream is so
uncertain, I think it is a good buy.” 15 Which of the following statements best describes
c “Since everyone else in the market seems to why people discount future payments?
think Glitzsoft’s stock price will rise, I am not a People prefer current consumption to future
going to buy it.” consumption and they discount uncertain future
d “Since everyone else in the market seems to payments.
think Glitzsoft’s stock price will rise, I am going b People prefer future consumption to current
to buy it.” consumption and they discount uncertain future
e “I think that Glitzsoft stock will rise in value payments.
next year, so I am not going to buy some now, c People prefer current consumption to future
since the dividend payments are low.” consumption and they discount stock market
12 You are considering buying a share of stock. The d People prefer future consumption to current
company is expected to earn $40 per share next consumption and they discount stock market
year, but is expected to only pay a dividend of bubbles.
$20. You expect the value of the share to be e Rational expectations require them to discount
$100 next year. Your discount factor is 0.75. the future.
What is the most you will be willing to pay for
252 CHAPTER 35
Risk and Return 20 Which of the following does not affect real stock
16 What happens if people discover that a stock’s a New technologies.
prices are going to fluctuate even more than b Taxes.
usual in the future? c Interest rates.
a People discount the stock more, leading to a d Monetary policy.
lower current price and a higher expected return. e Inflation.
b People discount the stock less, leading to a lower
current price and a higher expected return. 21 Which of the following best describes how
c People discount the stock more, leading to a interest rates affect stock prices?
higher current price and a higher expected a Higher interest rates mean more risk, and
return. therefore lead to lower stock prices.
d People discount the stock more, leading to a b Higher interest rates encourage stockholders to
lower current price and a lower expected return. buy more shares, seeking the higher returns.
e People discount the stock less, leading to a c Higher interest rates make borrowing more
higher current price and a lower expected return. expensive, and this leads to less spending and
lower earnings for firms.
17 What is the cost of using portfolio d Higher interest rates encourage bondholders to
diversification? switch to stocks.
a Your risk goes up. e Higher interest rates raise wealth, and therefore
b You are more likely to get caught in a speculative encourage people to buy fewer shares.
c You are ignoring market fundamentals, and will 22 Which of the following best describes how taxes
likely earn a negative return. affect stock prices?
d You expected return is lower. a Taxes make stocks riskier, and therefore lead to
e You must borrow to carry out the diversification. lower stock prices.
b Taxes reduce firms’ earnings, and lead to lower
18 Which of the following statements about stock stock prices.
market risk is false? c Taxes increase capital gains, and lead to higher
a Portfolio diversification reduces risk. stock prices.
b People discount riskier stocks more. d Taxes reduce capital gains, and lead to higher
c Riskier stocks usually pay a risk premium. stock returns and higher stock prices.
d Riskier stocks usually sell for a higher price. e Taxes reduce the number of transactions, and
e People will accept lower expected returns to therefore reduce the demand for stocks.
23 How do investors profit by anticipating the
The Stock Market and the Economy central bank’s monetary policy?
a If they expect expansionary monetary policy,
19 Which of the following statements best describes they will sell stocks before the stock prices fall.
the timepath of real stock earnings in the last b If they expect expansionary monetary policy,
140 years? they will buy stock before the stock prices rise.
a Real stock earnings had no distinct upward or c If they expect contractionary monetary policy,
downward trend, but fluctuate a lot. they will buy stock before the stock prices rise.
b Real stock earnings had no distinct upward or d If they expect contractionary monetary policy,
downward trend, except for burst of high they will sell stock before the stock prices rise.
earnings growth in the 1890s, 1950s/1960s and e If they expect an increase in taxes, they will buy
1990s. stock before the stock prices rise.
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 downward
trend, with lots of fluctuations.
G L O B A L S TO C K M A R K E T S 253
24 Why do increases in the value of the stock 4 Morgan’s discount rate is 0.8. Lubaba’s discount
market lead to a lower saving rate? rate is 0.75. They are each considering buying
a With more wealth, people wish to buy more the stocks listed in Table 35.3 below, which also
stocks, and take the money out of their savings. shows each person’s evaluation of the expected
b With more wealth, people spend less, leading to dividend and price of the stock. Each stock sells
lower saving. for $100 per share. Explain whether or not they
c With more wealth, people are less worried about will buy each stock, and explain why you know.
risk, and spend more on stocks and save less.
d With more wealth, people spend more on TA B L E 35.3 S TO C K D I V I D E N D A N D
consumption, and save less. F U T U R E P R I C E E S T I M AT E S
e With more wealth, firms find their earnings Bobbie’s Dolls’n’Toys Maxwell’s MP3 Mart
increasing, and save less.
Estimated Future Estimated Future
25 Which of the following statements is correct? Dividend Price Dividend Price
1 During the 1990s, the saving rate excluding Morgan $10 $120 $4 $110
capital gains decreased in Canada. Lubaba $12 $125 $2 $140
2 During the 1990s, the saving rate including
capital gains increased in Canada.
a 1 only. 5 With respect to your answers to Short Answer
b 2 only. Problem 4, how would your answers change if
c Both 1 and 2. you found out Morgan and Lubaba lived in a
d Neither 1 nor 2. province with a capital gains tax?
e 1 is true, 2 is not measurable.
6 Microsoft announced in January of 2003 that it
Short Answer Problems would pay a dividend. It has never paid a
dividend before then. Why would people want
1 Consider the information in Table 35.2 on to hold a stock that pays no dividend?
a Fill in the remainder of the table. 7 According to the market fundamentals view, the
ct b Why did Glitzsoft still pay a dividend, even price of a stock depends only on the stream of
when its earnings were negative? expected future dividend payments. Explain
c Why did investors still keep the stock price high briefly why.
in 2001, when Glitzsoft had negative earnings?
8 When James Tobin won the Nobel Prize in
2 Explain how and why riskier stocks pay higher Economics, he was asked to explain in simple
expected returns. words the theory of risk diversification that won
him the Nobel Prize. His answer “Don’t put all
ct 3 The stock market rose dramatically in value in your eggs in one basket.” In terms of buying
Canada and especially in the United States in stocks, why shouldn’t you put all your eggs in
the 1990s. Do you think this was due to a one basket?
speculative bubble, or to a change in market
fundamentals due to the introduction of new 9 Your granny maintains a large portfolio of
technologies. Explain your reasoning briefly. stocks. She has heard that she should be
following monetary policy in order to properly
TA B L E 35.2 G L I T Z S O F T S TO C K
Year Earnings Dividend Stock Price-Earnings Dividend Rate of
Ending 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
254 CHAPTER 35
look after her portfolio. She would like you to 8 d See text discussion. (832–833)
explain why she should follow monetary policy. 9 e Stockholders have limited liability, companies
frequently reinvest earnings, and Bombardier
10 Why did the measured saving rate (excluding only gets the sale price for the initial sale.
capital gains) collapse in Canada and the United (830–835)
States in the late 1990s? 10 a b is nonsense, c or d would be speculative
bubble views, and e is wrong, might buy.
11 d Herd behaviour. (838–839)
A N S W E R S 12 d Willingness to pay = 0.75 × ($20 + $100).
True/False and Explain 13 d Since future earnings/dividends expected to
be lower, current willingness to pay falls,
1 F It is a share of profits. (831) current price falls. (836–838)
2 F 75% = (10 + (25 – 20))/20 × 100. (831) 14 a Trying to pick who other people think is a
3 T Expected return = expected dividend + winning stock, as opposed to picking the best
expected capital gain. (831) stock. (838–839)
4 F They have risen, but with many fluctuations 15 a See text discussion. (836)
up and down. (832–833) 16 a React to extra uncertainty by increasing
5 F Carried out on a stock market. (830–832) discount rate, lowering willingness to pay and
6 T Definition. (836–837) current price, raising expected returns. (840)
7 T Individuals look at the expected value of the 17 d See text discussion. (840)
discounted dividend and future price, and 18 d Sell for lower price. (840)
since the future price depends on future 19 c See Text Figure 35.6. (841)
dividends, then they are really looking only at 20 e Real earnings control for inflation effects.
the stream of expected future dividends. (841–845)
(838) 21 c Lower earnings for firms means lower
8 T People dislike uncertainty, so their willingness dividends, and lower willingness to pay, lower
to pay is lower. (836–838) price. (842–843)
9 T Defined by self-fulfilling expectations. 22 b Taxes do lower capital gains, but this leads to
(838–839) lower current stock prices. (843)
10 T Riskier stock means lower demand, which 23 b Expansionary policy will lead to lower interest
leads to a lower price holding constant future rates, higher stock prices in the future.
price, which means a higher expected capital (842–843)
gain and higher expected return. (840) 24 d Capital gains are part of wealth, and spending
11 T Portfolio diversification reduces range of depends on wealth. (843–845)
possible outcomes. (840) 25 a See text discussion around Text Figures 35.7
12 T See text discussion. (841–842) and 35.8. (844–845)
13 F Higher interest rates lead to lower spending
by consumers, lower earnings by firms, lower Short Answer Problems
stock prices. (842–843)
14 T Higher taxes mean lower net earnings for 1 a Table 35.2 is filled in on the next page as
firms, lower return for stockholders, lower Table 35.2 Solution.
demand for stock. (843) ct b It paid a dividend to keep its stockholders
15 T Capital gains mean rising wealth, and less happy, and to keep them holding the stock.
need to save. (843–845) c The investors were expecting that the future
stream of earnings would be positive.
2 Investors do not like risk, so they will show a
1 a Definition. (830) lower willingness to pay, by discounting a riskier
2 d Change in price. (831) stock by more than a less risky stock with the
3 d Dividend – capital loss. (831) same expected dividend payments and future
4 c Return as a percent of 1999 price. (831) price. This extra discounting will mean a lower
5 c Dividend as a percent of 2000 price. (831) current price for the stock. Since the current
6 c 90/5. (831) price is lower, but the future expected price is
7 b They fluctuate a great deal. (832–835) the same, the riskier stock will pay an higher
expected capital gain and higher expected return.
G L O B A L S TO C K M A R K E T S 255
TA B L E 35.2 G L I T Z S O F T S TO C K
Year Earnings Dividend Stock Price-Earnings Dividend Rate of
Ending 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%
3 Any answer to this question is a value future. Combining discounting, dividends and
judgement, but should be based on an the right to sell, we can logically see that
argument. In favour of the speculative bubbles
P1 = expected value of [discount rate ×
view, we see a strong rise and decline in stock
(dividend + future price)]
prices, the strongest rise in history, out of
proportion to the changes in earnings. In favour The expected future price, by logic, will also
of the market fundamentals view, we see that depend on the expected future dividend.
earnings were strong in the 1990s, and we see Substituting in all these expected future prices
there was an unusual technological revolution tells us that the current price will depend on the
going on, just as in previous situations where stream of expected future payments.
stocks rose sharply. The big unresolved question
is whether or not the earnings rise is strong and 8 Putting all your eggs in one basket (investing
permanent enough to justify the higher prices. everything in one stock) is riskier than holding a
mixture of stocks in your portfolio—portfolio
4 Each person will calculate their willingness to diversification. Holding the mixture of stocks
pay based on the formula: means that the actual potential range of your
earnings is smaller then if you held only one
P1 = expected value of [discount rate ×
type of stock.
(dividend + future price)]
For Morgan, Bobbie’s Dolls’n’Toys is worth 9 Monetary policy affects interest rates, which in
$104 = 0.8 x [$10 + $120] to her. Maxwell’s is turn affect stock prices. For example, if interest
worth $91.20 = 0.8 × [$4 + $110] to her. She rates fall in value, then stock prices will be
will buy a share of Bobbie’s, but not of Maxwell’s affected via two routes. First, the lower interest
stock. rates will encourage more borrowing (and less
For Lubaba, Bobbie’s Dolls’n’Toys is worth saving) and more spending by consumers and
$102.75 = 0.75 × [$12 + $125] to her. business, which in turn will lead to more
Maxwell’s is worth $106.50 = 0.75 × [$2 + earnings for firms, and higher future dividends.
$140] to her. She will buy a share of both stocks. As a result, the expected return on stocks is
higher, and your granny should buy more.
5 If either person has to pay capital gains taxes, we Secondly, the lower interest rates will lower
would have to use the after-tax value of the the return on stocks, and individuals (including
capital gain in our calculations, and this would your granny) will switch from bonds to stocks.
reduce the potential return on any stock. This increase in demand will also increase the
Morgan and Lubaba would not start buying one price of stocks, so your granny might like to
of the stocks they have already rejected, and they anticipate this increase by buying stocks now.
may reject buying one of those they have
accepted, if the tax rate is high enough to reduce 10 The strong rise in the value of stock markets in
the willingness to pay below $100. Canada and the United States added to the wealth
of households—the change in wealth was positive
6 The investors anticipated that future earnings or due to the paper capital gains they earned. As a
future capital gains would give them the return result of the higher wealth, households spent
they are looking for. more and saved less out of their current
disposable income—the saving rate plummeted.
7 Individuals prefer current consumption to future Another way to think of this is to note that
consumption, and they dislike uncertainty. For their savings rate including capital gains did not
these two reasons, they discount future payments. plummet—they did indeed save (accumulate
Buying a stock entitles you to a share of future wealth).
dividends, and to the right to sell the stock in the
C h a p t e r s
P a r t 33–35
1 0 W r a p U p
d The prime minister has been considering asking
P R O B L E M the Bank of Canada to defend the dollar more
strongly, but is worried about the impact on the
You are an advisor to the prime minister, stock market. Briefly explain to her the impact
specializing in exchange rate considerations. The of defending the Canadian dollar on the stock
Canadian dollar is suffering from a crisis of market.
nonconfidence on world markets, sparked by an
ct e The prime minister asks you whether she should
economic crisis in Asia. Foreign investors are ask the Bank of Canada to defend the dollar
afraid that Canada’s economy will be hurt by the even more strongly, or not. What do you think?
Asian economic crisis, since Asia buys many
commodities from Canada. The investors are
afraid that profits and returns at Canadian
companies will decrease dramatically. Foreigners MIDTERM EXAMINATION
start a selloff of Canadian assets.
a Explain to the prime minister (with the aid of a You should allocate 24 minutes for this examination
graph showing the demand and supply of dollars) (12 questions, 2 minutes per question). For each
what this will imply for the value of the Canadian question, choose the one best answer.
dollar, as well as for interest rates, the value of the
monetary base and the money supply, and the 1 The short-run adjustment costs in Canada
three balance of payments accounts. (The Bank of associated with reducing the level of tariffs under
Canada is operating under a rule of trying to a North American Free Trade Agreement will be
stabilize the exchange rate.) borne principally by
b Another advisor to the prime minister has told
a taxpayers, whose higher taxes provide the
her that the Bank of Canada should be ordered
generous retraining programs.
to increase the money supply to try and lower
b employers and workers in those sectors in which
interest rates. What will this do to the value of
Canada has a comparative advantage.
the exchange rate and to foreign holdings of
c employers and workers in those sectors in which
Canadian assets? Can the Bank of Canada do
Canada has a comparative disadvantage.
this and still maintain a managed exchange rate?
d Canadian consumers of imported goods.
c The prime minister has received a phone call
e Canadian producers of exported goods.
from the owner of Big Importer Company,
complaining that the change in the value of the
2 Table P10.1 below shows some information on
Canadian dollar has hurt his ability to sell
the dividend payments and stock prices on a
imported whatzits in Canada. With the aid of a
yearly basis for Present Shop Inc. What is the
graph of the market for whatzits in Canada
capital gain on Present Shop stock between 2001
(with the vertical axis measuring the price of
whatzits in Canadian dollars), explain to the
prime minister what has happened to the price a $20.00
and quantity imported in this market. What has b $32.00
happened to exports? to the balance of trade? c $45.00
U N D E R S TA N D I N G T H E G L O B A L E C O N O M Y 257
7 You are considering buying a share of stock. The
TA B L E P10.1 P R E S E N T S H O P S TO C K
company is expected to earn $50 per share next
Year Earnings Dividend Stock year, but is expected to only pay a dividend of
Ending per Share Payments Price $25. You expect the value of the share to be
2001 $15.00 $12.00 $125.00
$200 next year. Your discount factor is 0.8.
2002 $20.00 $12.00 $145.00
What is the most you will be willing to pay for
3 Which of the following quotations best describes b $225
the interest rate parity effect? c $200
a “The recent high Canadian interest rate has d $180
increased the demand for the Canadian dollar.” e $160
b “The market feeling is that the Canadian dollar
is overvalued and will likely appreciate.” 8 If Fullofland is currently a net lender and a
c “The price of bananas is the same in Canada and debtor nation,
the United States, adjusting for the exchange a it has loaned more capital than it borrowed
rate.” abroad this year, but borrowed more than it
d “The expected appreciation of the Canadian loaned during its history.
dollar is currently lowering demand for it.” b it has borrowed more capital than it loaned
e None of the above. abroad this year and also borrowed more than it
loaned during its history.
4 Which of the following statements with regard c it has loaned more capital than it borrowed
to stock market risk is true? abroad this year and has loaned more than it
a Portfolio diversification increases risk. borrowed during its history.
b People discount riskier stocks less. d its accounting system must be in error if it shows
c Riskier stocks usually pay a risk premium. this nation to be a net lender and a debtor
d Riskier stocks usually sell for a higher price. nation at the same time.
e People need lower expected returns to accept e its debts must be currently growing.
9 Suppose Musicland and Videoland produce two
5 Atlantis imports watches from Beltran and goods—CDs and videos. Musicland has a
exports widgets to Beltran. Why would Atlantis comparative advantage in the production of
prefer arranging a voluntary export restraint CDs if
rather than a quota on watches? a fewer CDs must be given up to produce one
a to not hurt Beltran’s imports unit of videos than in Videoland.
b to prevent Beltran from retaliating by restricting b less labour is required to produce one unit of
Atlantis’ exports CDs than in Videoland.
c to keep the domestic price of watches low c less capital is required to produce one unit of
d to increase government revenue CDs than in Videoland.
e to help domestic producers d less labour and capital are required to produce
one unit of CDs than in Videoland.
6 Which of the following would cause the dollar e fewer videos must be given up to produce one
to depreciate against the yen? unit of CDs than in Videoland.
a an increase in the Canadian monetary supply 10 Which of the following changes is likely to
b an increase in interest rates in Canada increase real stock earnings?
c a decrease in interest rates in Japan
d an increase in the expected future exchange rate a Introduction of new technologies.
e a decrease in the current exchange rate b Higher corporate profits taxes.
c Higher interest rates.
d Contractionary monetary policy.
e Higher capital gains taxes.
258 PA R T 1 0 W R A P U P — C H A P T E R S 3 3 – 3 5
11 Acadia and Breton are currently engaged in free
trade. Acadia imports cheese from Breton and
exports sheep to Breton. If Acadia imposes a
Value of the Dollar
tariff on cheese, Acadia’s cheese-producing
industry will S
a expand, and its sheep-producing industry will ➡
b expand, and its sheep-producing industry will Fa a
c contract, and its sheep-producing industry will Fb b
d contract, and its sheep-producing industry will
e expand, and its sheep-producing industry will be
Quantity of Dollars
12 Canada has a trade deficit when the
a value of Canadian exports of goods and services b A lower interest rate would spark a further
exceeds the value of Canadian imports of goods decrease in the demand for the Canadian dollar,
and services. as foreigners buy fewer Canadian assets, given the
b value of Canadian exports of goods and services lower Canadian interest rate differential. This
is exceeded by the value of Canadian imports of would tend to push down the Canadian dollar’s
goods and services. value, which would conflict with the Bank of
c value of Canadian exports of goods exceeds the Canada’s attempts to stabilize the exchange rate.
value of Canadian imports of goods. c The market for whatzits is shown in Figure
d value of Canadian exports of goods is exceeded P10.2. The new, lower exchange rate of fewer
by the value of Canadian imports of goods. U.S. dollars per Canadian dollar means more
e current account balance is less than zero. Canadian dollars per U.S. dollar, and acts like a
tariff—it increases the Canadian dollar price of
the imported whatzits, shown as the shift
A N S W E R S leftward in the supply curve. This change leads
to a new equilibrium, with a higher price, and a
Problem lower quantity imported and sold.
The market for Canadian exports would be
a The fear of lower future returns leads to a acting in an opposite manner, with lower prices
decrease in the demand for Canadian dollar and more exports. The higher exports and lower
assets, leading to a decrease in the demand for imports will mean the balance of trade (and hence
Canadian dollars. In Figure P10.1, this decrease, the current account) is moving towards a surplus.
in turn, leads to a decrease in the value of the d Defending the Canadian dollar involves
exchange rate from Fa to Fb. To keep it from shrinking the money supply, and raising interest
decreasing even further, the Bank of Canada rates. Higher interest rates lead to a) less
intervenes and buys Canadian dollars, supplying borrowing, less consumption and investment
foreign exchange from official reserves. They also expenditure and less revenue earning by firms,
might shrink the money supply, which will tend and lower demand for stocks, as well as b) stock
to increase Canadian interest rates. (There are holders selling their stock and shifting to bonds.
also potential supply effects not shown here.) The net effect is lower stock prices.
Foreigners are lending us less, so the capital ct e The answer is a value judgement, and depends
account will move towards a smaller surplus or a on the value you place on defending the
deficit. The decrease in the foreign exchange value Canadian dollar (for example, helping the
of the Canadian dollar will lead to an increase in importer) versus the damage the defense might
exports and a decrease in imports (see part c do to the Canadian economy. Defending the
below), so that the current account will move Canadian dollar will entail buying Canadian
towards a surplus. Since the Bank of Canada is dollars (which will shrink the domestic money
supplying foreign exchange, this is a decrease in supply), and raising Canadian interest rates.
reserves, or a movement towards a surplus. Both of these actions will depress aggregate
demand and put downward pressure on real
GDP and jobs. It is your call.
U N D E R S TA N D I N G T H E G L O B A L E C O N O M Y 259
4 c Because people do not like riskier stocks, they
discount them more, leading to a lower price,
New Foreign and a higher return. (840)
Price of Whatzits
5 b Under a VER, exporting country gains excess
revenue, which means it is less likely to
retaliate, since hurt less. (794–796)
6 a a decreases interest rates, which decrease
Pb b Original Foreign
demand for Canadian dollars. b–d are
Pa a increase in demand, e move along, not a shift.
7 d Price = discount rate × (expected dividend +
expected future price). (836–838)
Canadian Import 8 a Definitions of net lender and debtor nation.
Demand Debts are shrinking. (812)
9 e Definition. (787–788)
Qb Qa 10 a It leads to higher earnings for firms.
Thousands of Whatzits (841–845)
11 a Tariff increases domestic price of cheese,
which decreases imports, which increases
domestic production. Decreased imports =
Midterm Examination decreased exports in Breton, which decreases
its income, which decreases its imports =
1 c Because decrease in U.S. or Mexican prices decrease in Acadia’s exports, decreasing
implies decrease in Canadian production. Acadia’s sheep production. (794–795)
(802–803) 12 b Definition of balance of trade. (810)
2 a Change in market price of stock. (831)
3 a If two currencies do not have the same
interest rate, market conditions will change
the demand for assets and the dollar.