Chapter Four Business Cycles BUSINESS CYCLES AND REASONS FOR BUSINESS FLUCTUATIONS... 4-1 Recession Phase Deflation EXPANSION, OR RECOVERY, PHASE... 4-2 Peak Phase Unemployment
Chapter Four Business Cycles Business cycles and reasons for business fluctuations The business cycle refers to the continual ebb and flow of economic activity. No two cycles are exactly the same. The business cycle is characterized by changes in real Gross Domestic Product (GDP) and other measures such as the rate of unemployment and the rate of inflation. There are four phases of the business cycle. The intensity and duration of these phases will vary from one business cycle to the next. The four phases are 1. peak, 2. recession (contraction), 3. trough, and 4. expansion (recovery) as shown in the graph below: Peak R E A L G D P Peak Recession (Contraction) Trend Line Expansion (Recovery) Trough TIME (In Years) The length of the business cycle is measured by the time elapsed between the peaks. The recession phase is characterized by increasing unused productive capacity associated with increasing unemployment. The increasing unemployment causes reduced spending and the reduced spending in conjunction with higher levels of unused capacity usually results in a decline in output (GDP). A decline in GDP for two or more quarters constitutes a recession. However, because many prices are inflexible in terms of price reduction, the price level is likely to decline only if the recession is intense and of long duration. Recessions of high intensity and long duration are called depressions. Deflation is the opposite of inflation in that during a period of deflation the price levels decline. If price levels are declining, consumers tend to postpone spending in the hopes of paying lower prices in the future. Therefore, governments go to great lengths to avoid deflation by means of monetary and fiscal policy. When the economy has realized its lowest level of production (GDP) in the business cycle, a trough has been reached. The trough phase in the business cycle is never recognized until the expansion phase is well under way. Thus, the trough phase can only be recognized in retrospect. What appears to be a trough phase may only be a slight pause in a continuing recession phase. The trough phase may last only a short time or it could persist for a long period. 4-1
The expansion, or recovery, phase is characterized by decreasing unemployment, greater utilization of productive capacity and an increase in real GDP. As the expansion phase progresses, the shrinking unused capacity and declining number of unemployed make it more likely that there will be inflationary pressures. As the expansion phase progresses, spending occasioned by the higher level of employment will increase. That increased spending, when considered against a backdrop of actual production creeping closer to productive capacity may lead to more aggressive pricing by producers. The higher levels of income increase demand for products but the diminishing unused productive capacity limits the supply. The result is increased inflationary pressure. It is during the expansion, or recovery, phase that businesses are likely to make capital expenditures to increase their productive capacity. However, these capital expenditure decisions are not likely to be made until the expansion, or recovery, phase is well under way. The peak phase is the period during which the economy has reached its highest level of production (GDP) in the business cycle. At the peak, there is often full employment and the level of real output is near the productive capacity. It is at this point that there is likely to be significant upward pressure on price levels as demand increases and supply is restricted by diminished available capacity. The economy of the United States of America has experienced several recessions in the past fifty years. The duration of those recessions varied from approximately one-half year to two years. The trend however, when measured by Gross Domestic Product, has been consistently upward. That upward growth is suggested by the trend line in the graph shown above. Although we have explained the phases of business cycles in terms of the level of unused productive capacity and the level of unemployment, the more basic cause of business cycles is total spending as measured by GDP. If total spending declines, production is curtailed to avoid building inventory in the face of declining demand for the products. The result is that unemployment increases and income falls. When the total spending increases, higher levels of production become possible, employees are hired, and incomes rise. However, as the economy nears full employment and the factories approach full productive capacity, further increases in production output become more difficult to achieve. At this point, further increases in total spending will put pressure on prices as consumers earning higher incomes bid for the limited quantity of goods available. Business cycles affect all sectors of the economy. However, all sectors are not affected to the same extent. Companies producing capital goods and consumer durable goods are greatly affected by business cycles. These companies produce high priced items that require considerable thought and analysis prior to purchase. In the case of capital goods (buildings, trucks, machinery and technology), considerable analysis precedes the decision to purchase. That analysis includes a projection of future cash flows and the calculation of the internal rate of return. If the internal rate of return is not sufficiently high, the purchase of the capital asset will be postponed. In the case of consumer durable goods (automobiles, appliances, furniture and houses), the consumer gives considerable thought to an acquisition. The consumer is unlikely to make the purchase unless the consumer has a genuine need and has the income necessary to support the purchase. On the other hand, service goods ( haircuts, doctor visits and entertainment) provided by service industries and nondurable consumer goods (toiletries, food, and fuel) are purchased without much analysis. These purchases are not likely to be postponed until the expansion, or recovery, phase of the business cycle. It is true that the quantity and quality of services and non-durable consumer goods demanded will decline during a recession phase; however, the decline will not be nearly as severe as for capital goods and consumer durable goods. In considering all aspects of the business cycle, it is necessary to discuss the various measures of unemployment. The natural rate of unemployment is the long-run rate of unemployment that would exist even if there were no cyclical unemployment. It is important to consider that the unemployment rate cannot reach zero. People are always switching jobs, getting fired, or quitting. As a result, when the real unemployment rate is equal to the natural rate of unemployment, the economy is deemed to be at full employment. Therefore, when the economy is at full employment, there are still unemployed people. The frictionally unemployed are capable workers who are between jobs and have not been matched-up with their next job yet. The frictionally unemployed also include those young people who are looking for their first job. Frictional unemployment is caused by limited information, unfortunate timing, and geographical separation between potential 4-2
employer and potential employee. The structurally unemployed include workers who have skills that do not match up to the skills necessary for a particular job. Structural unemployment typically results from technological changes in the workplace. Another type of unemployment is cyclical unemployment. Cyclical unemployment is caused by fluctuations in the business cycle. Cyclical unemployment usually occurs when the GDP begins to decline and the economy begins to go into the a recession. The graph below shows the relationship that exists among these various types of unemployment: Structural Unemployment Frictional Unemployment Natural Unemployment Total Unemployment Cyclical Unemployment 4-3
Chapter Four - Business Cycles Multiple Choice Questions 1. During the recession phase of a business cycle, a. the purchasing power of money is likely to decline rapidly. b. the natural rate of unemployment will increase dramatically. c. potential national income will exceed actual national income. d. actual national income will exceed potential national income. 2. The trough of a business cycle is generally characterized by a. shortages of essential raw materials and rising costs. b. increasing purchasing power and increasing capital investments. c. rising costs and an unwillingness to risk new investments. d. unused productive capacity and an unwillingness to risk new investments. 3. Recurring upswings and downswings in an economy s real Gross Domestic Product over time are called: a. recessions. b. business cycles. c. output yo-yos. d. total product oscillations. 4. In the United States, business cycles have occurred against a backdrop of a long-run trend of: a. declining unemployment. b. stagnant productivity growth. c. rising real Gross Domestic Product d. rising inflation. 5. The immediate determinant of the volume of output and employment is the: a. composition of consumer spending. b. ratio of public goods to private goods production. c. level of total spending. d. size of the labor force. 6. In which of the following industries or sectors of the economy is output likely to be most strongly impacted by the business cycle? a. military goods. b. producer s durables (machinery or equipment). c. textile products (clothing). d. agricultural commodities (wheat or corn). 7. During a prolonged recession, we would expect output to fall the most in: a. the health care industry. b. the clothing industry. c. agriculture. d. the construction industry. 8. The phase of the business cycle in which real Gross Domestic Product declines is called: a. the peak. b. a recovery. c. a recession. d. the trough. 9. The phase of the business cycle in which real Gross Domestic Product is at a minimum is called: a. the peak. b. a recession. c. the trough. d. a recovery. 10. Market economies have been characterized by: a. occasional instability of employment and price levels. b. uninterrupted economic growth. c. persistent full employment d. declining populations. 11. The production of durable goods varies more than the production of nondurable goods because: a. durable purchases are non-postponable. b. durable purchases are postponable. c. the producers of nondurables have monopoly power. d. Producers of durables are highly competitive. 12. A recession is a period in which: a. cost-push inflation is present. b. potential domestic output falls. c. demand-pull inflation is present. d. real domestic output falls. 13. The natural rate of unemployment is: a. higher than the full-employment rate of unemployment. b. lower than the full-employment rate of unemployment. c. that rate of unemployment occurring when the economy is operating at its full potential. d. found by dividing total unemployment by the size of the labor force. 4Q-1
14. If the unemployment rate is 9 percent and the natural rate of unemployment is 5 percent, then the: a. frictional unemployment rate is 5 percent. b. cyclical unemployment rate and the frictional unemployment rate together are 5 percent. c. cyclical unemployment rate is 4 percent. d. natural rate of unemployment will eventually increase. 15. The natural rate of unemployment: a. is fixed over time. b. is found by adding the cyclical and structural unemployment rates. c. may change from one decade to another. d. cannot be changed through public policy. 16. The natural rate of unemployment is the: a. unemployment rate experienced at the depth of a depression. b. full-employment unemployment rate. c. unemployment rate experienced by the least-skilled workers in the economy. d. unemployment rate experienced by the most-skilled workers in the economy. 17. Cyclical unemployment results from: a deficiency of aggregate spending. b. the decreasing relative importance of goods and the increasing relative importance of services in the economy. c. the everyday dynamics of a free labor market. d. technological change. 18. Structural unemployment: a. is also know as frictional unemployment. b. is the main component of cyclical unemployment. c. is said to occur when people are waiting to be called back to previous jobs. d. may involve a locational mismatch between unemployed workers and job openings. 19. The type of unemployment associated with a recession is called: a. frictional unemployment. b. structural unemployment. c. cyclical unemployment. d. seasonal unemployment. 20. Which of the following constitute the unemployment occurring at the natural rate of unemployment? a. frictional and cyclical unemployment. b. structural and frictional unemployment. c. cyclical and structural unemployment. d. frictional, structural, and cyclical unemployment. 21. All the following are characteristic of the recessionary stage of the business cycle EXCEPT: a. It eventually leads to a trough. b. Unemployment levels rise. c. Prices fall more rapidly than economic activity falls. d. Output levels decline. 22. If John s expectations of sustained economic growth are correct, which of the following correctly pairs an investment vehicle with an economic scenario, likely to exist under the growth assumption, that would make the investment attractive? a. Short-term debt instruments: sustained economic growth will cause a substantial increase in interest rates. b. Real estate: sustained economic growth will induce high inflation. c. Common stock: sustained economic growth will entail a neutral fiscal and monetary policy, but firms with prospects for consistent earnings growth will prosper. d. Cyclical common stocks: sustained economic growth will cause interest rates to fall, thus spurring demand. 23. Which of the following combinations of investments would be best for the investor in an environment of high inflation? (1) Common stock in companies with large holdings of oil, precious metals, or land (2) Collectibles (3) Short-term liquid assets like U.S. Treasury bills and money market funds. (4) Common stock of public utility companies. a. (1) and (2) only b. (3) and (4) only c. (1), (2), and (3) only d. (2), (3), and (4) only 24. Which of the following combinations of investments would be best when the economy is undergoing deflation? (1) Long-term bonds rated AA or higher (2) Long-term bonds raced CC or lower (3) Common stocks of firms with sizeable financial leverage (4) Short-term U.S. Treasury bills a. (2) and (3) only b. (1) and (4) only c. (1), (2), and (4) only d. (1), (3), and (4) only 4Q-2
25. David believes that we are moving into a period of deflation. If David s expectations concerning deflation are correct, which of the following correctly pairs an investment vehicle with an appropriate logic? a. Savings and loan common stocks: deflation will cause savings and loans to lend at higher rates. b. Precious metals: deflation will cause these assets to increase in value. c. Long-term, high-quality bonds: deflation will cause interest rates to decrease. d. Short-term bonds: deflation will cause short-term interest rates to increase. 26. Tracy is concerned that inflation will increase soon. Given an inflationary economic environment, which one of the following investment vehicles would be most appropriate for Tracy to purchase? a. Automotive stocks: inflation will cause cyclical stocks to increase in value. b. Precious metals: inflation will cause these assets to increase in value. c. Long-term bonds: inflation will cause interest rates to increase. d. Short-term bonds: inflation will cause interest rates to decrease. 27. If an investor held long-term U.S. Treasury bonds currently, the investor would most likely sell them and hold money if he or she believed that interest rates will: a. Rise far above present levels. b. Not change from present levels. c. Fluctuate up and down within a narrow range. d. Fall below present levels. 28. The controller of Gray, Inc. has decided to use ratio analysis to analyze business cycles for the past two years in an effort to identify seasonal patterns. Which of the following formulas should be used to compute percentage changes for account balances for year 1 to year 2? a. (Prior balance - current balance) / current balance. b. (Prior balance - current balance) / prior balance. c. (Current balance - prior balance) / current balance. d. (Current balance - prior balance) / prior balance. 4Q-3
Chapter Four Business Cycles Answers to Multiple Choice Questions 1. Answer (c) is the correct answer. Productive capacity would support a higher national income than the actual income during a recession phase. Answer (a) is not correct because in a recession phase there is not likely to be inflation and it is inflation that causes the purchasing power of money to decline. Answer (b) is not correct because the natural rate of unemployment tends not to change. It represents the sum of the frictionally and the structurally unemployed. Answer (d) is not correct because potential national income is related to productive capacity. During a recession the actual production (GDP) is less than the productive capacity. 2. Answer (d) is the correct answer. At the trough, there is considerable unused capacity. However, because a trough is not recognized until the expansion is clearly under way, investments are postponed until it is clear the expansion is under way. Answer (a) is not correct because there are unlikely to be shortages of essential raw materials when production is at a reduced level. Likewise, in a trough, inflationary pressures are unlikely. Answer (b) is not correct because increased investment is not likely until it is clear that an expansion phase is under way. When the economy is in a trough, it is not clear how long it will remain that way. Answer (c) is not correct because rising costs are not usually present until the economy is well into the expansion phase as actual production approaches capacity and incomes increase as a result of reduced unemployment. 3. Answer (b) is the correct answer. Business cycles are measured by changes in GDP. Answer (a) is not correct because recessions are caused only by the downswings in GDP. Answer (c) is not correct because output yo-yos is a nonsensical answer. Answer (d) is not correct because the answer is a nonsensical answer. 4. Answer (c) is the correct answer. The trend line of GDP has been a growth trend line. Answer (a) is not a correct answer because the natural rate of unemployment tends to remain unchanged or even increase as the population grows. Answer (b) is not correct because the trend has been an increase in GDP and GDP reflects increases in production. Answer (d) is not correct because the trend in inflation has been declining as GDP increases. 5. Answer (c) is the correct answer. Total spending has the greatest influence on production and higher production causes higher employment which will also increase spending. Thus, fiscal policy often increases government spending or decreases taxes in order to jump-start the economy. Answer (a) is not the correct answer because the volume of output is influenced by government, business, and consumer spending, not just consumer spending. Answer (b) is not correct because private goods and public goods production is part of the volume of output rather than a determinant of the volume of output. Answer (d) is not the correct answer because the size of the labor force is of no consequences to the volume of output. The size of the labor force is not the same as the unemployment rate; and it is the unemployment rate that is a determinant of the volume of output. 6. Answer (b) is the correct answer. Durable goods are the types of goods that require considerable thought and analysis prior to the decision to invest. If the economy is in a recessionary phase, decision makers are faced with increasing unused capacity. They are not likely to invest in durable goods under those conditions. Answer (a) is not correct because the purchase of military goods is not likely to be influenced by the business cycle. Decisions about military acquisitions are more likely to be influenced by geopolitical considerations. Answer (c) is not correct because clothing is considered a necessity and its purchase is not the result of considerable thought and analysis. Answer (d) is not correct because agricultural commodities are considered necessities and their purchase is not preceded by considerable thought and analysis. 7. Answer (d) is the correct answer. The construction industry is based on business decisions that require considerable thought and analysis. During a prolonged depression, there would be excess capacity and businesses are not likely to expand capacity through construction until such time as the expansionary phase is well under way. Answer (a) is not correct because the health care industry is based on purchases that are considered a necessity. Answer (b) is not correct because the clothing industry is based on purchases that are considered a necessity. Answer (c) is not correct because the agriculture industry is based on purchases that are considered a necessity. 8. Answer (c) is the correct answer. A recession is characterized as a period during which production is measured by GDP declines for two or more quarters in a row. Answer (a) is not correct because the peak is the high point in the business cycle when there is neither increase or decrease. Answer (b) is not the correct answer because the recovery 4S-1
phase is the phase in which GDP increases. Answer (d) is not correct because the trough is the low point in the business cycle when there is neither increase or decrease. 9. Answer (c) is the correct answer. The trough is the lowest point in the business cycle. Answer (a) is not correct because the peak is the highest point in the business cycle. Answer (b) is not correct because a recession is defined as an economy which has been in decline for two or more quarters. Answer (d) is not correct because a recovery is defined as an economy that has been through the trough and GDP is increasing. 10. Answer (a) is the correct answer. Market economies are always subject to economic cycles. Economic cycles are characterized by instability of employment levels and price levels. Planned economies are not nearly as inclined toward instability. Answer (b) is not correct because, even though market economies tend to have long-term growth, the growth is frequently interrupted by business cycles. Answer (c) is not correct because market economies will always have frictional and structural unemployment (natural level of unemployment) plus cyclical unemployment because of business cycles. Answer (d) is not correct because market economies attract workers from other economies and thus, the population of countries with market economies tends to increase. 11. Answer (b) is the correct answer. Durable goods, as contrasted to consumer goods, are postponable. Durable goods include machinery, transportation equipment, and building construction. Answer (a) is not correct because it is nondurable goods (consumer goods such as toiletries, food, and clothing) that are regarded as non-postponable. Answer (c) is not correct because the producers of nondurable goods (toiletries, food, and clothing) operate in nearly perfectly competitive markets where there are many buyers and many sellers. Answer (d) is not correct because the producers of durable goods tend to operate in a market where there are many buyers but few sellers. 12. Answer (d) is the correct answer. Real domestic output, as measured by real GDP, falls during a recession. In fact, a recession is defined as a period in when GDP declines for two or more consecutive quarters. Answer (a) is not correct because no form of inflation is likely to be present when spending, employment, and GDP are declining as in a recession. Answer (b) is not correct because potential domestic output remains unchanged during a recession. Potential domestic output is measured by the productive capacity of the economy. Answer (c) is not correct because no form of inflation is likely to be present when spending, employment, and GDP are declining as in a recession. 13. Answer (c) is the correct answer. The natural rate of unemployment is what is left after the cyclical unemployment has been eliminated. That elimination of the cyclical unemployment is likely to occur when the economy is at the peak of a business cycle. Answer (a) is not correct because the natural rate of unemployment is essentially the same as the fullemployment rate of unemployment. Answer (b) is not correct because the natural rate of unemployment is essentially the same as the full-employment rate of unemployment. Answer (d) is not correct because the answer is a nonsensical answer. 14. Answer (c) is the correct answer. The unemployment rate is the sum of the natural rate of unemployment plus the cyclical unemployment rate. Answer (a) is not correct because the natural rate of unemployment is the sum of the frictional unemployment rate and the structural unemployment rate. Answer (b) is not correct because the unemployment rate is the sum of the cyclical unemployment rate and the natural rate of unemployment. Answer (d) is not correct because one cannot draw conclusions about the increase or decrease of the natural rate of unemployment by knowing only the unemployment rate and the natural rate of unemployment. Changes in the natural rate of unemployment are gradual and they are related to changes in society. 15. Answer (c) is the correct answer. The natural rate of unemployment is likely to change from one decade to the next as a result of societal changes such as demographic changes and other societal changes. Answer (a) is not correct because the natural rate of unemployment is likely to change to reflect societal changes. Answer (b) is not correct because the natural rate of unemployment is the sum of the frictional unemployment and the structural unemployment. Answer (d) is not correct because the natural rate of unemployment is influenced by societal changes. 16. Answer (b) is the correct answer. The natural rate of unemployment is the rate of unemployment that is experienced when there is no cyclical unemployment. Answer (a) is not correct because at the depth of a depression there would be considerable cyclical unemployment in addition to the always present natural rate of unemployment. Answer (c) is not correct because the unemployment rate of the least-skilled workers in the economy is not ordinarily measured. Answer (d) is not correct because the unemployment rate of the most-skilled workers in the economy is not ordinarily measured. 4S-2
17. Answer (a) is the correct answer. Aggregate spending impacts GDP and a deficiency in aggregate spending will tend to reduce GDP. A reduction in GDP will result in cyclical unemployment. Answer (b) is not correct because if the decreasing GDP related to goods is offset by the increasing GDP related to services, there is not likely to be any increase in cyclical unemployment. Answer (c) is not correct because it is the natural rate of unemployment that results from the everyday dynamics of a free labor market. Answer (d) is not the correct answer because structural unemployment is caused by technological change. 18. Answer (d) is the correct answer. Structural unemployment is related to geographical separation between the location of the worker and the location of the job opening. Answer (a) is not correct because structural unemployment and frictional unemployment are components of the natural rate of unemployment. Answer (b) is not correct because structural unemployment is a component of the natural rate of unemployment. Answer (c) is not correct because people waiting to be called back to their previous jobs are classified as the frictionally unemployed. 19. Answer (c) is the correct answer. Cyclical unemployment is caused by declining GDP and declining GDP is associated with a recession. Answer (a) is not correct because frictional unemployment is a component of the natural rate of unemployment and the natural rate of unemployment is not likely to change in response to a recession. Answer (b) is not correct because structural unemployment is a component of the natural rate of unemployment and the natural rate of unemployment is not likely to change in response to a recession. Answer (d) is not correct because seasonal unemployment is unemployment caused by seasonal changes rather than changes in GDP. 20. Answer (b) is the correct answer. The natural rate of unemployment is the sum of structural unemployment and frictional unemployment. Answer (a) is not correct because cyclical unemployment is added to the natural rate of unemployment to obtain total unemployment. Answer (c) is not correct because structural unemployment is an element of the natural rate of unemployment but cyclical unemployment is not. Answer (d) is not correct because frictional, structural and cyclical unemployment, taken together, constitute total unemployment. 21. Answer (c) is the correct answer. Economic activity, when measured by GDP, falls but prices are not likely to fall quite as rapidly. Prices tend to be rather sticky in a recession. Answer (a) is not correct because a recession will eventually lead to a trough. Answer (b) is not correct because unemployment rises in a recession. Answer (d) is not correct because output levels, when measured by GDP, decline during a recession. 22. Answer (c) is the correct answer. During a period of sustained economic growth, the economy is growing within a desirable range of possible growth rates, enabling government policy to adopt a neutral posture. Firms capable of generating consistent earnings growth will be good investments during a period when moderate inflation is the norm. Answer (a) is not correct because as long as growth is sustained, as opposed to breaking away on the upside, there is little reason for the Federal Reserve to tighten money and cause higher interest rates. Therefore there is little advantage in remaining very liquid with short-term instruments. Answer (b) is incorrect because sustained economic growth means economic growth without an unacceptably high inflation rate. Answer (d) is incorrect because interest rates would not be expected to fall, since Federal Reserve policy would be neutral, and loan demand would not be weak under an environment of sustained economic growth. 23. Answer (c) is the correct answer. Investments 1, 2, and 3 are all well suited for an environment of high inflation. Tangible assets such as land, oil, precious metals, and collectibles have traditionally done well during such periods. High inflation is usually accompanied by high interest rates, since the inflation premium in the interest rate expands. During periods of rising interest rates, short-term liquid assets can be reinvested at higher and higher interest rates. Answer (a) is not correct because there is one more type of investment that would also be advantageous. Answer (b) is not correct because public utilities are highly leveraged with debt and the higher interest rates associated with high inflation would cause increasing costs. Answer (d) is not correct because public utilities are highly leveraged with debt and the higher interest rates associated with high inflation would cause increasing costs. 24. Answer (b) is the correct answer. Long-term AAA rated bonds will lock in the higher interest rates of the past, plus insure confidence that the debt will be serviced during the period when bankruptcies are increasing. Short-term U. S. Treasury bills have zero credit risk, and the purchasing power of this investment is increasing as prices for goods and services are falling as a result of deflation. Answer (a) is not correct because long-term bonds rated CC or lower and common stocks of firms with sizeable leverage are dangerous investments in deflation. The bonds risk default and the companies that are highly leveraged could experience a decline in earnings during a deflationary period. Those decreased earnings could make payment of interest on the debt difficult or impossible. Answer (c) is not correct because long-term 4S-3
bonds rated CC or lower are dangerous investments in deflation. The bonds risk default. Answer (d) is not correct because companies that are highly leveraged could experience a decline in earnings during a deflationary period. Those decreased earnings could make payment of interest difficult or impossible. 25. Answer (c) is the correct answer. Deflation is a period of tepid demand, declining prices of goods and services, declining interest rates, and rising bankruptcies among the weaker firms. Long-term bonds rated AA or higher are good investments in deflationary times. Answer (a) is incorrect because interest rates will be falling. A lender will be unable to lend at higher interest rates. Answer (b) is incorrect because tangible assets such as precious metals will decline in price during a deflationary economy. Answer (d) is incorrect because the economic logic is faulty. Short-term interest rates will decline in a deflationary economy. 26. Answer (a) is the correct answer. If interest rates rise far above the present levels, there will be a sharp drop in the price for bonds now held. By selling and holding cash, the investor could again buy the bonds when the price dropped, avoiding a possible capital loss and pocketing a substantial gain on the transactions. Answer (b) is not correct because holding the bonds will result in declining market price as interest rates increase. Answer (c) is not correct because it is an increase in interest rates that causes the market price of existing bonds to decline. Answer (d) is incorrect because if interest rates fall from present levels, the market value of the bonds would increase; thus, the investor should continue to hold them. 27. Answer (b) is the correct answer. Precious metals are good investments in inflationary periods. Answer (a) is incorrect because inflation causes interest rates to rise, which decreases demand for postponable, durable goods such as automobiles and houses. Answer (c) is incorrect because higher interest rates will cause long-term bond prices to decline. Answer (d) in incorrect because inflation will cause interest rates to increase, not decrease. 28. Answer (d) is the correct answer. For example, if sales in the current year are $100 million compared to $80 million in the prior year, the change in sales would be a $20 million increase. The percentage increase would be the raw increase of $20 million divided by the prior year's sales of $80 million for a percentage increase of 25%. 4S-4