Part I: Multiple Choice Questions:
Problem 1. Which of the following is likely to lead to expansionary/inflationary monetary policy?
a. Rising unemployment
b. Rising government budget deficits
c. Declining oil prices
d. All of the above will likely lead to expansionary/inflationary monetary policy
e. Only (a) and (b) will likely lead to expansionary/inflationary monetary policy
Problem 2. A difference between the M3 and L measures of the aggregate money supply is that only L includes
a. Bank long-term repurchase agreements
b. Small denomination time deposits
c. Demand deposits at banks
d. Short-term Treasury securities
e. Term Eurodollars
Problem 3. The demand for an asset will tend to ________ with a decrease in liquidity relative to other assets and _______ when the riskiness of an asset increases relative to other assets.
a. increase: remain the same
b. decrease; increase
c. decrease; decrease
d. increase; increase
e. increase; decrease
Problem 4. According to the article “Where is all the U.S. currency hiding?”, which of the following is true?
a. The 1993 estimated figure says that about 80% of all U.S. currency is held within the U.S.
b. Deceleration in the narrow money measures always portends a weakening economy.
c. (a) and (b) are both true.
d. Large swings in overseas holdings of U.S. currency typically have a large impact on the current level of domestic economic activity.
e. None of the above statements is true.
Problem 5. Which of the following is included in the M2 monetary aggregate?
a. Treasury Bills
b. Bankers acceptances
c. Commercial paper
d. Negotiable CDs
e. Small-denomination time deposits
Problem 6. According to the article “Why is Europe forming a Monetary Union?”, which of the following is true?
a. Each country of the European Monetary Union can use its own monetary policy to boost its economy.
b. It is beneficial to use a single currency because it reduces transactions costs.
c. Each country of the European Monetary Union can use its own fiscal policy with no limitations as long as the government budget deficit will be offset by the government surplus in the long run.
d. (a) and (b) are true statements.
e. (a) and (c) are true statements.
Problem 7. Which of the following is an example of indirect finance?
a. Joe, a mountain bike shop owner, obtains a business loan from a local credit union
b. A bank sells an existing mortgage agreement to an individual investor
c. Karen buys 50 shares of Dairy Queen on E-trade
d. A large chemical firm sells a number of long-term bonds to individual investors in order to finance a new ethylene glycol plant
e. (a) and (b)
Problem 8. According to the loanable funds approach, which of the following would happen if the expected inflation rate falls (holding everything else constant)?
a. The bond demand curve will shift to the right and the bond supply curve will shift to the left. The equilibrium bond price will increase and the equilibrium interest rate will decrease from their initial levels. The equilibrium quantity of bonds will be indeterminate.
b. The bond demand curve will shift to the left and the bond supply curve will shift to the left. The equilibrium bond price and the equilibrium interest rate will be indeterminate while the equilibrium quantity of bonds will decrease.
c. The bond demand curve will shift to the right and the bond supply curve will also shift to the right. The equilibrium bond price and the equilibrium interest rate will be indeterminate while the equilibrium quantity of bonds will increase.
d. The bond demand curve will shift to the left while the bond supply curve does not shift. The equilibrium quantity of bonds will increase, the equilibrium bond price will increase and the equilibrium interest rate will decrease.
e. None of the above are true.
Problem 9. On Tuesday, March 22, 2003, Alan Greenspan, Chairman of the Federal Reserve Board, received news that unusually inclement weather had devastated the Caribou herds of Northern Canada, causing the price of imported Caribou steaks, fur, and antlers to skyrocket. Fearing a sharp increase in inflation across the United States, Greenspan announces that he will probably move to increase interest rates over the next quarter year. This unexpected interest rate hike will have varying effects on the prices of different securities. Consider the following three securities:
Treasury bonds (with maturity 10 years from now)
Shares of common stock
Overnight repurchase agreements
Rank these securities from the largest percent change in price to the lowest percent change in price.
a. Treasury bonds, shares of common stock, overnight repurchase agreements
b. Overnight repurchase agreements, shares of common stock, Treasury bonds
c. Overnight repurchase agreements, Treasury bonds, shares of common stock
d. Shares of common stock, Treasury bonds, overnight repurchase agreements
e. Treasury bonds, overnight repurchase agreements, shares of common stock
Problem 10. According to the textbook, which of the following is true?
a. Prices and returns for long-term bonds are more volatile than those for shorter-term bonds.
b. Prices and returns for long-term bonds are less volatile than those for shorter-term bonds.
c. Prices and returns for long-term bonds are almost the same as those for shorter-term bonds.
d. Prices and returns for long-term or shorter-term bonds do not move together in a systematic way.
e. Prices and returns for long-term bonds are equal to prices and returns for shorter-term bonds in equilibrium.
Problem 11. Along the demand curve for loanable funds,
a. The behavior of borrowers is insensitive to changes in the level of interest rates.
b. The level of wealth in the economy is held constant.
c. The level of wealth in the economy is allowed to vary.
d. (a) and (b)
e. (a) and (c)
Problem 12. For a zero-coupon bond, the yield to maturity is determined by the bond’s face value and its
a. purchase price.
b. current yield.
c. coupon rate.
d. expected inflation rate.
e. None of the above are true.
Problem 13. If a bond’s yield is equal to its coupon rate, then all of the following are correct except
a. the bond is undervalued.
b. the bond sells at its face value.
b. the bond’s yield to maturity equals its current yield.
d. the bond’s coupon rate equals its yield to maturity.
e. None of the above are false statements.
Problem 14. Which of the following is true?
a. Yield on a discount basis overstates the more accurate measure of the interest rate, the yield to maturity.
b. Yield on a discount basis understates the more accurate measure of the interest rate, the yield to maturity.
c. The longer the maturity of the discount bond, the smaller the error of yield on a discount basis becomes.
d. (a) and (b) are true.
e. (a) and (c) are true.
Problem 15. An increase in the growth rate of the money supply (holding everything else constant) is most likely to be followed by
a. a decline in economic activity.
b. an increase in the price level.
c. an expansion of economic activity.
d. all of the above
e. (b) and (c)
Problem 16. The most prominent role for money is to serve as a
a. form of credit.
b. source of income.
c. means of payment.
d. standard of value.
e. store of value.
Problem 17. Every 20th century recession in the United States has been preceded by a decline in
a. the exchange rate.
b. the average price level.
c. the rate of money growth.
d. the money stock.
e. the price of gold.
Problem 18. According to the loanable funds approach, which of these will result in the equilibrium interest rate falling?
a. A decrease in the supply of loanable funds.
b. A decrease in the demand for loanable funds.
c. An increase in the supply of loanable funds.
d. An increase in the demand for loanable funds.
e. (b) or (c).
Problem 19. When income tax rates are _______, interest rates on Treasury bonds ______ relative to the interest rates on state and local bonds.
a. lowered; fall
b. lowered; rise
c. raised; fall
d. raised; do not change
e. raised; do not change
Problem 20. A consol bond that pays $10 per year is worth ________ at a nominal interest rate of 20%.
a. $100
b. $100
c. $500
d. $200
e. $50
Part II: Problems (6 points each)
Q1. According to the loanable funds framework, what would happen to the equilibrium interest rate and the equilibrium quantity of bonds if, simultaneously,the liquidity of bonds relative to other assets decreases and the profitability of investment increases? Be sure to draw a diagram to illustrate whether the demand curve or/and the supply curve would shift and in what direction. In your graph you should label both the x axis and the y axis, any curves that you draw, the initial equilibrium interest rate and quantity of bonds, and the new equilibrium interest rate and quantity of bonds once the loanable funds market has adjusted. Be sure that your labels are clear (do not assume that the grader will recognize your abbreviations!). Provide a written summary of the effects of these changes on the equilibrium interest rate and the equilibrium quantity of bonds.
Q2. Consider an asset that gets a return of 0% thirty percent of the time, a return of 10% thirty percent of the time, and a return of 20% forty percent of the time. Calculate the asset’s expected return and risk. Remember to show your work (no full credit for just answers!) and to indicate what abbreviations stand for in you work. Partial credit is not possible unless we can follow the work that you are doing in the problem: i.e., neatness and organization matter.
a. Expected return calculation:
b. Risk Calculation:
Q3. This question relaxes the assumption of a constant discount rate throughout a bond’s maturity period. Suppose your uncle wishes to buy a newly issued 2-year bond with a face value of $1000 and a coupon rate of 10%. You expect the real interest rate to hold steady at 4% from now until the bond’s maturity date. You also expect the inflation rate to hold steady for the first year, then change to another rate (and stay at that rate) for the second year of the bond’s life. If inflation was 2.5% for the first year and you computed a bond price of $1050, what inflation rate did you expect for the final year when pricing the bond? Remember to show your work (no full credit for just answers!) and to indicate what abbreviations stand for in you work. Partial credit is not possible unless we can follow the work that you are doing in the problem: i.e., neatness and organization matter.
III. Essay
Suppose the leaders of Canada, The United States, and Mexico meet to design a single currency for the continent. Suppose, furthermore, that these leaders have learned a lesson from the experience of the European Monetary Union (recall the article you read “Why is Europe forming a Monetary Union?”). In your essay,
a. Identify and discuss three distinct advantages to a monetary union.
b. Identify and discuss the primary disadvantage to a monetary union.
c. Assess the potential effects of this proposed monetary union: in making this assessment take either a pro or con side and argue that position.