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Chapter 28: Problem 13

In its 2016 Annual Report, Toll Brothers noted, "If mortgage interest rates increase significantly \(\ldots\) our revenues, gross margins, and net income could be adversely affected." a. Why might an increase in mortgage interest rates reduce revenue and profit for Toll Brothers? b. During this period, was Fed policy attempting to reach a point on the short-run Phillips curve representing higher unemployment and lower inflation or a point representing higher inflation and lower unemployment? Briefly explain. c. What connection is there between Fed policy and Toll Brothers' concern about the effect of rising mortgage interest rates on its profit?

Short Answer

Expert verified
An increase in mortgage interest rates likely reduces the demand for homes, thereby decreasing Toll Brothers' revenue. Higher interest rates also mean higher borrowing costs for Toll Brothers, impacting its net profit. Regarding the Fed policy, it would depend on the economic conditions - if the Fed aims for lower inflation at the expense of higher unemployment, it means interest rates are being raised. Increased rates can lead to reduced demand for homes, affecting Toll Brothers' profit.

Step by step solution

01

Understanding the impact of interest rates on business

Higher mortgage interest rates make borrowing more expensive, which deters potential homebuyers. This could lead to decrease in demand for houses - and thus, a decrease in revenues for Toll Brothers. Also, when interest rates rise, Toll Brothers may have to pay more on its own loans, which could impact net income negatively, resulting in reduced profit.
02

Interpreting Fed Policy

The Federal Reserve's policy varies based on the economic conditions. During the period, if the Fed policy was trying to reduce inflation and thus, increased interest rates, it would be aiming for a point on the short-run Phillips curve representing higher unemployment and lower inflation. If the policy was to stimulate the economy through lower interest rates, it would be trying to achieve a point representing higher inflation and lower unemployment.
03

Establishing the Link between Fed Policy and Toll Brothers

Fed policy plays a key role in determining mortgage interest rates. If the Federal Reserve raises interest rates to curb inflation, mortgage rates would increase as well. This increase in rates will affect Toll Brothers as mentioned in step 1. Thus, there's an indirect link between the Fed's monetary policy and Toll Brothers' concerns about the effect of rising mortgage rates on its profits.

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Most popular questions from this chapter

When Robert Shiller asked a sample of the general public what they thought caused inflation, the most frequent answer he received was "corporate greed." Do you agree that greed causes inflation? Briefly explain.

In macroeconomics courses in the \(1960 \mathrm{~s}\) and early \(1970 \mathrm{~s},\) some economists argued that one of the U.S. political parties was willing to have higher unemployment in order to achieve lower inflation and that the other major political party was willing to have higher inflation in order to achieve lower unemployment. Why might such views of the trade-off between inflation and unemployment have existed in the 1960 s? Why are such views rare today?

(Related to the Apply the Concept on page 1000) When Robert Shiller asked a sample of the general public what they thought caused inflation, the most frequent answer he received was "corporate greed." Do you agree that greed causes inflation? Briefly explain.

An article in the Economist started by stating that "central banks cannot endlessly reduce unemployment without sparking inflation is economic gospel. It follows from 'a substantial body of theory, informed by considerable historical evidence,' according to Janet Yellen, chair of the Federal Reserve." a. Use a graph of the Phillips curve to show that central banks cannot endlessly reduce unemployment without sparking inflation. Briefly explain how your graph illustrates this point. Give an example of historical evidence that Fed Chair Yellen could be referring to. b. The article stated that the "effects of unemployment on inflation can get lost amid temporary economic gyrations. That is most obvious when oil prices fall, as they did in late 2014." What does the article mean by the "effects of unemployment on inflation can get lost amid temporary economic gyrations?" Use a graph of the Phillips curve to show the effect on inflation of a fall in oil prices. Briefly explain what is happening in your graph. c. In discussing the effect of inflationary expectations, the article stated that "self-fulfilling expectations could explain low inflation." Use a graph of the Phillips curve to show how self-fulfilling expectations could explain low inflation. Briefly explain what is happening in your graph.

An opinion column in the Wall Street Journal noted, "In a democracy, the tradeoff for a central bank's independence is accountability to the nation's elected leadership." a. Why would a country want to grant its central bank more independence than it grants, say, its department of agriculture or department of education? b. In the United States, how is the Fed held accountable to the nation's elected leadership? Source: David Wessel, "Explaining 'Audit the Fed," Wall Street Journal, February 17, 2015 .
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