Chapter 05 - Economic Activity

SOLUTIONS MANUAL
CHAPTER 5
ECONOMIC ACTIVITY
Answers to Text Discussion Questions
1. As depicted in Figure 51, what are the three elements in the valuation process?
5-1.

The three elements in the valuation process are economic analysis, industry
analysis and company analysis.

2. As shown in Figure 55, what are the four goals under the Employment Act of 1946?
5-2.

Stable prices (a low inflation rate)

Business stability at high levels of production (low levels of unemployment)
Sustained economic growth (real growth in gross domestic product)
A balance in international payments (primarily a balance of exports and imports
but also including cash flows in and out of the U.S.)

3. What is fiscal policy? A one-sentence definition will suffice.

5-3.

Fiscal policy is the federal government's taxing and spending policies.

4. What is monetary policy?

5-4.

Monetary policy is conducted by the Federal Reserve Board of Governors through

several policies of controlling the money supply and interest rates.

5. How, specifically, can the Fed influence economic activity? Name three ways!
5-5.

The Federal Reserve Board can raise or lower reserve requirements on bank
deposits, which affects the money supply. It can change the discount rate, which is
the interest rate the Federal Reserve charges banks for short-term loans. The Fed
can also buy and sell securities for its own portfolio through its open market
operations. It can also jawbone or talk to the markets in ways that influence
behavior. All of these tend to influence the money supply, interest rates, and the
economy.

6. In regard to Federal Reserve open-market activity, if the Fed buys securities, what is
the likely impact on the money supply? Is this likely to encourage expansion or
contraction of economic activity?
5-6.

The impact will be to increase the money supply. This tends to be expansionary in
terms of economic activity.

5-1

Chapter 05 - Economic Activity

7. What is the historical relationship between real GDP and inflation? What lesson might
be learned from observing this relationship?
5-7.

The change in real GDP is inversely related to the rate of inflation in a normal
economy. As inflation rises, real GDP falls. It does no good to stimulate the
economy only to have all gains eroded by inflation. In simple terms Real GDP =
Nominal GDP Inflation.

8. In terms of the business cycle, distinguish between a trough and a peak.

5-8.

A trough represents the end of a recession and the beginning of an expansion, and
a peak represents the end of an expansion and the beginning of an expansion.

9. What are the four basic areas that make up gross domestic product? Over the past three
decades, what area has been growing most rapidly?
5-9.

The four basic areas that make up gross domestic product are:
1. Personal consumption expenditures
2. Government purchases
3. Gross private investment
4. Net exports
Personal consumption expenditures are growing most rapidly.

10. What is the advantage of using a composite of indicators (such as the 10 leading
indicators) over simply using an individual indicator?
5-10. Statistically one gets a more accurate picture by using a composite of indicators.
Erratic changes in one indicator tend to be offset by movements in other
indicators. The composite tends to be a better predictor than an individual series.
11. Do leading indicators tend to give longer warnings before peaks or before troughs?
What is the implication for the investor?
5-11. The warning is generally longer before peaks than troughs. The investor must be
careful not to miss a quick turn-around to the upside, but can be more patient in
anticipating a decline. The stock market often anticipates the end of a recession
and stock prices usually turn up before real GDP shows an increase.
12. Comment on whether each of the following three industries is sensitive to the
business cycle. If it is sensitive, does it do better in a boom period or a recession?
a. Automobiles
b. Pharmaceuticals
c. Housing

5-2

Chapter 05 - Economic Activity

5-12. a. Automobiles are sensitive to the business cycle and do better in a boom period.
b. Pharmaceuticals are a necessity and are usually not dependent on the economy.
c. Housing is sensitive to the economy and does better in a recession with low
interest rates.
13. Observe the performance of the 10 leading indicators for the next month. Compare
this with changes in stock prices and interest rates.
5-13. Answers will vary.

5-3