1) Currently the yield on the 10 year treasury note is ~ 184 basis points (1.84%) above the yield on the 2 year treasury note. Although it is normal to see higher yields on longer term treasuries, these maturity yield differentials are substantially greater than the yield differentials that have been typical over the last 30 years
a) Why are longer term treasury yields usually somewhat higher than yields on shorter term treasury notes.
b) What do the unusually large maturity yield differentials noted above suggest about investor expectations of future short term interest rates? Explain your answer clearly.
2) Suppose the CFO of an American corporation with surplus cash flow has $100 million to invest and the corporation does not believe it will need to utilize these funds to retool or expand production capacity for 1 year. Suppose further that the interest rate on 1 year CD deposits in US banks is 1 %, while the rate on 1 year CD deposits (denominated in Australian dollars) is currently 2.7 %. Suppose further that the exchange rate currently is (.9) Australian Dollars per US $.
What must the CFO expect about the Australian Dollar/US$ exchange rate 1 year from now if she chooses to invest in the US $ CD's instead of the Australian CD's? (Note: a specific numeric answer is required for full credit. Part credit can be earned for correctly identifying and discussing the issue here without a specific numeric answer.)
3) Between February 2008 and Summer 2009 the Fed supplemented its open market operations with a greatly expanded program of direct lending (both overnight and short term 28 and 84 day loans) to commercial banks, investment banks, brokerage and primary dealer units of bank holding companies. It also agreed to accept a wider range of short term securities (instead of accepting only T-Bills) as collateral on these loans and even initiated a program to buy commercial paper from money market funds.
A) Explain why the Fed created all these extraordinary direct lending facilities, instead of simply relying on traditional open market purchases of Treasury securities.
B) As conditions in short term financial markets improved by summer of 2009 the Fed closed down its lending under these programs. However, throughout 2009 and in the first quarter of 2010 the Fed increased substantially its purchases of longer term mortgage backed securities and treasury notes from banks as it wound down its unusual lending loan facilities. Moreover, the Fed embarked on a renewed program of large scale purchases ($600 Billion total) of Treasury notes in the Fall of 2010, which it continued until June 30 of 2011.
What is the effect of these programs on banks' balance sheets?
What would believers in the quantity theory of money (monetarists) expect to result from these large scale purchases of securities by the Fed? Explain your answer in a paragraph and discuss the concept of the velocity of circulation in your answer.
C) Assume that at some point in the next year or two both lender & borrower confidence levels start to return to normal and financial and physical investment levels start to rise much more strongly than in the last 2 years.
What potential problem will the extraordinary growth in banks' reserve deposits that has resulted from Quantitative Easing create then for the Fed?
How will the Fed's relatively recent authorization to pay interest to banks on their reserve accounts at the Fed help the Fed deal with this problem? Explain.
4) Recently, the Fed announced after an open market committee meeting that despite some improvement in private sector job creation in recent months, it felt economic conditions warranted retention of its currently low Fed funds rate of 0 to .25% until well into 2014. Previously it had merely said that it would keep that rate low for "an extended period of time" Most observers felt that an extended period of time meant 6 to 9 months.
Why do you think Bernanke wanted to let investors know that the Fed was thinking about extending current exceptionally low fed funds rates for over 2 years...not just 6 to 9 months?
5) Given the current condition of the US economy, do you think US policy makers would prefer to see the $ rise in value, decline in value or stay at its current value? Discuss the advantages and disadvantages to the US economy at this time of a stronger vs. a weaker $. Frame your answer in terms of the current Aggregate Demand and Aggregate Supply behavior of the US economy.
6) Signs of investor uneasiness in continuing to purchase treasury securities issued by heavily indebted sovereign states such as Greece, Ireland or Portugal have triggered a debate about raising the debt ceiling here. Newly elected "Tea Party" republicans in the House of Representatives have made "out of control" growth in government spending a point of attack on incumbent democrat legislators a rallying cry in their campaigns since fall 2010 and insist that any legislation to balance the Federal Budget over the next few years must rely solely on reductions in Government spending and transfer programs with no tax increases. The Republican candidates for president all repeat this party line as well. Democrats insist that some significant portion of any deficit reduction package must be based on closing tax loopholes and increasing marginal tax rates on wealthy households (income greater than $1 million). They also argue that although credible deficit reduction measures need to be put in place soon, the actual phase-in of those measures-whether tax increases or reductions in entitlement spending programs --must be gradual and await a strengthening of RGDP growth in the US economy.
Given the current situation of the US economy, compare and contrast the views of a "Keynesian", to those of a "Supply Sider" with respect to the issues in this debate.