3) New information that might lead to a decrease in a stock's price might be A) an expected decrease in the level of future dividends. B) a decrease in the required rate of return.
C) an expected increase in the dividend growth rate. D) an expected increase in the future sales price. Answer: A
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4) A change in perceived risk of a stock changes A) the expected dividend growth rate. B) the expected sales price. C) the required rate of return. D) the current dividend. Answer: C
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5) A stock's price will fall if there is A) a decrease in perceived risk.
B) an increase in the required rate of return. C) an increase in the future sales price. D) current dividends are high. Answer: B
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6) A monetary expansion ________ stock prices due to a decrease in the ________ and an increase in the ________, everything else held constant. A) reduces; future sales price; expected rate of return B) reduces; current dividend; expected rate of return C) increases; required rate of return; future sales price D) increases; required rate of return; dividend growth rate Answer: D
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7) The global financial crisis lead to a decline in stock prices because A) of a lowered expected dividend growth rate.
B) of a lowered required return on investment in equity. C) higher expected future stock prices. D) higher current dividends. Answer: A
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8) Increased uncertainty resulting from the global financial crisis ________ the required return on investment in equity. A) raised B) lowered
C) had no impact on D) decreased Answer: A
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7.3 The Theory of Rational Expectations
1) Economists have focused more attention on the formation of expectations in recent years. This increase in interest can probably best be explained by the recognition that
A) expectations influence the behavior of participants in the economy and thus have a major impact on economic activity.
B) expectations influence only a few individuals, have little impact on the overall economy, but can have important effects on a few markets.
C) expectations influence many individuals, have little impact on the overall economy, but can have distributional effects.
D) models that ignore expectations have little predictive power, even in the short run. Answer: A
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2) The view that expectations change relatively slowly over time in response to new information is known in economics as A) rational expectations. B) irrational expectations.
C) slow-response expectations. D) adaptive expectations. Answer: D
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3) If expectations of the future inflation rate are formed solely on the basis of a weighted average of past inflation rates, then economists would say that expectation formation is A) irrational. B) rational. C) adaptive. D) reasonable. Answer: C
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4) If expectations are formed adaptively, then people
A) use more information than just past data on a single variable to form their expectations of that variable.
B) often change their expectations quickly when faced with new information.
C) use only the information from past data on a single variable to form their expectations of that variable.
D) never change their expectations once they have been made. Answer: C
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5) If during the past decade the average rate of monetary growth has been 5% and the average inflation rate has been 5%, everything else held constant, when the Federal Reserve announces that the new rate of monetary growth will be 10%, the adaptive expectation forecast of the inflation rate is A) 5%.
B) between 5 and 10%. C) 10%.
D) more than 10%. Answer: A
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6) The major criticism of the view that expectations are formed adaptively is that A) this view ignores that people use more information than just past data to form their expectations.
B) it is easier to model adaptive expectations than it is to model rational expectations. C) adaptive expectations models have no predictive power.
D) people are irrational and therefore never learn from past mistakes. Answer: A
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7) In rational expectations theory, the term \A) correct forecast. B) the correct guess. C) the actual outcome. D) the best guess. Answer: D
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8) If a forecast is made using all available information, then economists say that the expectation formation is A) rational. B) irrational. C) adaptive. D) reasonable. Answer: A
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9) If a forecast made using all available information is NOT perfectly accurate, then it is A) still a rational expectation.
B) not a rational expectation. C) an adaptive expectation. D) a second-best expectation. Answer: A
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10) If expectations are formed rationally, then individuals A) will have a forecast that is 100% accurate all of the time. B) change their forecast when faced with new information.
C) use only the information from past data on a single variable to form their forecast. D) have forecast errors that are persistently low. Answer: B
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11) If additional information is not used when forming an optimal forecast because it is not available at that time, then expectations are A) obviously formed irrationally.
B) still considered to be formed rationally. C) formed adaptively. D) formed equivalently. Answer: B
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12) An expectation may fail to be rational if
A) relevant information was not available at the time the forecast is made.
B) relevant information is available but ignored at the time the forecast is made. C) information changes after the forecast is made. D) information was available to insiders only. Answer: B
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13) According to rational expectations theory, forecast errors of expectations A) are more likely to be negative than positive. B) are more likely to be positive than negative. C) tend to be persistently high or low. D) are unpredictable. Answer: D
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14) When using rational expectations, forecast errors will, on average, be ________ and ________ be predicted ahead of time. A) positive; can B) positive; cannot C) negative; can D) zero; cannot Answer: D
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15) People have a strong incentive to form rational expectations because A) they are guaranteed of success in the stock market. B) it is costly not to do so. C) it is costly to do so.
D) everyone wants to be rational. Answer: B
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16) If market participants notice that a variable behaves differently now than in the past, then, according to rational expectations theory, we can expect market participants to A) change the way they form expectations about future values of the variable. B) begin to make systematic mistakes.
C) no longer pay close attention to movements in this variable. D) give up trying to forecast this variable. Answer: A
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17) According to rational expectations
A) expectations of inflation are viewed as being an average of past inflation rates.
B) expectations of inflation are viewed as being an average of expected future inflation rates. C) expectations formation indicates that changes in expectations occur slowly over time as past data change.
D) expectations will not differ from optimal forecasts using all available information. Answer: D
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18) Suppose Barbara looks out in the morning and sees a clear sky so decides that a picnic for lunch is a good idea. Last night the weather forecast included a 100% chance of rain by midday but Barbara did not watch the local news program. Is Barbara's prediction of good weather at lunch time rational? Why or why not?
Answer: No, this prediction is not using rational expectations. Although Barbara based her guess on the information that was available to her at the time, additional information was readily available that could have been used to improve her prediction. AACSB: Reflective Thinking
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