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Chapter 26: Q.10 (page 691)

From mid-2008 to early 2009 , the Dow Jones Industrial Average declined by more than 50%, while real interest rates were low or falling. What does this scenario suggest should have happened to investment?

Short Answer

Expert verified

Low genuine loan fees decrease the expense of funding speculation and, thus, empower venture spending

Step by step solution

01

Step 1. Concept of Dow Jones industrial average 

Instead of the number of stocks in the average, the Dow Jones industrial average is the proportion of the sum of components of stock prices divided by the divisor. Tobin was the first to describe the relationship between stock market and investment, and his explanation is known as Tobin's q.

02

Step 2. Explanation

Low real interest rates reduce the cost of financing investment and, as a result, encourage investment spending. When the stock market falls, the market valuations of the companies fall, and Tobin's q falls as well. The decrease in Tobin's q would result in a decrease in investment spending. Because of the massive collapse in Tobin's q and the stock market, investment spending dropped dramatically at this time.

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Most popular questions from this chapter

A "rate cycle" is a period of monetary policy during which the federal funds rate moves from its low point toward its high point, or vice versa, in response to business cycle conditions. Go to the St. Louis Federal Reserve FRED database, and find data on the federal funds rate (FEDFUNDS), real business fixed investment (PNFIC96), real residential investment (PRFIC96), and consumer durable expenditures (PCDGCC96). Use the frequency setting to convert the federal funds rate data to "quarterly," and download the data.

a. When did the last rate cycle begin and end? (Note: If a rate cycle is currently in progress, use the current period as the end.) Is this rate cycle a contractionary or an expansionary rate cycle?

b. Calculate the percentage change in business fixed investment, residential (housing) investment, and consumer durable expenditures over this rate cycle.

c. Based on your answers to parts (a) and (b), how effective was the traditional interest rate channel of monetary policy over this rate cycle?

Predict what will happen to stock prices after a monetary easing. Explain your prediction.

Suppose the economy is in recession and the monetary policymakers lower interest rates in an effort to stabilize the economy. Use an aggregate supply and demand diagram to demonstrate the effects of a monetary easing when the transmission mechanisms are functioning normally and when the transmission mechanisms are weak, such as during a deep downturn or when significant financial frictions are present.

"A decrease in short-term nominal interest rates necessarily implies a stance of monetary easing." Is this statement true, false, or uncertain? Explain your answer.

If adverse selection and moral hazard increase, how does this affect the ability of monetary policy to address economic downturns?
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