Midterm 2

Correct answers are in italics

Part I. Multiple Choice (60 points). Choose the single best answer for the following 20 questions.
Use the following figure for the next question:

1. The above figure illustrates the effect of an increased rate of money supply growth. From the figure, one can conclude that the
a. the liquidity effect is smaller than the other effects and interest rates adjust quickly to changes in expected inflation.
b. the liquidity effect is larger than the other effects and interest rates adjust quickly to changes in expected inflation.
c. the liquidity effect is smaller than the other effects and interest rates adjust slowly to changes in expected inflation.
d. the liquidity effect is larger than the other effects and interest rates adjust slowly to changes in expected inflation.

2. When the price level falls and the Fed increases the money supply at the same time,
a. the demand curve for money shifts to the right, the supply curve shifts to the right, and the interest rate rises.
b. the demand curve for money shifts to the left, the supply curve shifts to the left, and the interest rate rises.
c. the demand curve for money shifts to the left, the supply curve shifts to the right, and the interest rate falls.
d. the demand curve for money shifts to the right, and the supply curve shifts to the right, and the interest rate falls.
e. none of the above.


Use the following diagram to answer the next question:


3. In the above figure, the decline in the interest rate from i1 to i2 can be explained by
a. a decrease in income.
b. an increase in the price level.
c. an increase in money growth.
d. both (a) and (b) of the above.
e. both (a) and (c) of the above.

4. When the interest rate is below the equilibrium interest rate, there is an excess _____for (of) money and the interest rate will_____ .
a. demand; rise.
b. demand; fall.
c. supply; fall.
d. supply; rise.

5. Assume only you know that tomorrow the top marginal tax rate will rise. Which of the following actions leads to the highest level of wealth?
a. Increasing your holdings of U.S. government bonds today.
b. Selling your holdings of U.S. government bonds today.
c. Selling your holdings of State of Florida bonds today.
d. Doing nothing.

6. Other things equal, rising market interest rates encourage banks to
a. increase discount borrowings from the Fed
b. hold more excess reserves.
c. hold fewer excess reserves.
d. do both (a) and (b) of the above.
e. do both (a) and (c) of the above.

7. The preferred habitat theory of the term structure
a. suggests that markets for bonds of different maturities are completely separate because people have preferred habitats.
b. assumes that bonds of different maturities are perfect substitutes.
c. indicates that today's long-term interest rate equals the average of short-term interest rates that people expect to occur over the life of the long-term bond.
d. does none of the above.

8. If the yield curve is flat for short maturities and then slopes sharply upward for longer maturities, the preferred habitat hypothesis indicates that the market is predicting
a. a rise in short-term interest rates in the near future and a decline further out in the future.
b. constant short-term interest rates in the near future and a decline further out in the future.
c. constant short-term interest rates in the near future and a rise further out in the future.
d. a decline in short-term interest rates in the near future and a rise further out in the future. e. a decline in short-term interest rates in the near future and an even steeper decline further out in the future.

9. When the corporate bond market becomes less liquid, holding everything else constant,
a. the demand curve for corporate bonds shifts to the right, and the demand curve for Treasury bonds shifts to the right.
b. the demand curve for corporate bonds shifts to the right, and the demand curve for Treasury bonds shifts to the left.
c. the demand curve for corporate bonds shifts to the left, and the demand curve for Treasury bonds shifts to the right.
d. the demand curve for corporate bonds shifts to the left, and the demand curve for Treasury bonds shifts to the left.
e. the demand curves for corporate and Treasury bonds remain unchanged.

10. Which of the following statements is true?
a. A bank's assets are its sources of funds.
b. A bank's liabilities are its uses of funds.
c. A bank's balance sheet has the property that total assets equals total liabilities plus equity capital.
d. Each of the above.
e. Only (a) and (b) of the above.

11. All else the same, if a bank has more rate-sensitive liabilities than assets, then a(n) _____ in interest rates will _____ bank profits.
a. increase; increase
b. increase; reduce
c. decline; reduce
d. decline; not affect

12. In the simple deposit expansion model, if the required reserve ratio is 20% and the Fed buys $50 worth of government bonds, checkable deposits will
a. decrease $250.
b. increase $250.
c. decrease $500.
d. increase $500.
e. none of the above.

13. If a bank has excess reserves of $20,000 and demand deposit liabilities of $80,000, and if the reserve requirement is 20 percent, then the bank has actual reserves of
a. $16,000.
b. $6,000.
c. $26,000.
d. $20,000.
e. $36,000.

14. In the simple deposit expansion model, the Federal Reserve can decrease the level of reserves in the banking system by
a. buying government bonds.
b. selling government bonds.
c. increasing discount loans to banks.
d. doing either (a) or (c) of the above.
e. none of the above actions.

15. If a member of the nonbank public deposits currency in a bank,
a. the monetary base will remain unchanged, but reserves will fall.
b. the monetary base will remain unchanged, but reserves will rise.
c. the monetary base will fall, but currency in circulation will remain unchanged.
d. the monetary base will rise, but reserves will remain unchanged.
e. none of the above.

16. The money multiplier is negatively related to:
a. the currency-checkable deposit ratio.
b. the excess reserves ratio.
c. discount borrowings from the Fed.
d. all of the above.
e. only a and b.

17. If the actual excess reserves ratio is higher than the Fed had forecasted for the current period, then the Fed should ______ to ______ the money stock to its target level.
a. purchase bonds; increase.
b. extend discount loans; increase.
c. sell bonds; decrease.
d. (a) or (b) of the above.
e. none of the above.

18. If the Fed makes open market purchases at the same time that it lowers reserve requirements, the money supply will
a. rise.
b. fall.
c. remain unchanged.
d. rise at first, but then fall.

19. Other things equal, a decline in the marginal income tax rates should cause the
a. currency-checkable deposit ratio to rise.
b. currency-checkable deposit ratio to fall.
c. money multiplier to fall.
d. both (a) and (c) to occur.
e. both (b) and (c) to occur.

20. The currency-checkable deposits ratio is ______ related to bank panics, and is ____ related to the interest rate paid on checkable deposits.
a. negatively; negatively.
b. negatively; positively.
c. positively; negatively.
d. positively; positively.

Part II. Problems (10 points). Answer the following 3 questions. SHOW ALL WORK.

1. Assume the following prevailing interest rates: 1 year bonds yield 14% ; 2 year bonds yield bonds yield 25%; and the real interest rate is 3%. Using the Preferred Habitat Theory, what is the expected inflation rate for the second year (assuming the risk premium for 2 year bonds is 1%)?

31%


2. This question refers to the following balance sheet:

If interest rates rise by 5 percentage points, say, from 10 to 15%, what will happen to bank profits as measured by gap analysis?

-$500,000 = ($40 million - $50 million) * .05

3. Given the following facts, what is the money supply?
currency-checkable deposit ratio = . 1 discount loans = 250
excess reserves-checkable deposit ratio = . 02 nonborrowed base = 200
required reserve ratio on checkable deposits = . 10

MS = (1 +.1)/(.1+.02+.1) * (200 +250)= 2250


Part III. Essays (30 points). Answer 2 of the following 3 questions.

1. (a) Briefly explain the market segmentation theory of the term structure of interest rates. (4 points)

The market segmentation hypothesis argues that the short-term and long-term interest rates are determined by the supply and demand of each bond type and each market is separated from the other.

(b) How does the market segmentation theory explain the empirical fact that yield curves usually slope upwards (Be sure to include the relevant diagrams)? (4 points)

The yield curve slopes upward, according to the market segmentation theory, because the demand for short-term bonds is relatively higher than for long-term bonds. This results in a higher interest rate for long-term bonds than short-term bonds.


(c) Briefly explain the preferred habitat theory of the term structure of interest rates. (4 points)

The preferred habitat theory argues that long-term bond rates are a weighted average of short-term interest rates expected over a bond's life plus a risk premium.

(d) How does the preferred habitat theory explain the empirical fact that yield curves usually slope upwards ? (3 points)

The average yield curve, exclusive of the risk premium, should be flat since short-term interest rates rise as often as they fall. However, the addition to a risk premium to long-term interest rates makes the average yield curve upward sloping.


2. Answer the following two questions.

(a) Predict what will happen to the money supply if the Fed purchases bonds and the public lowers the currency-checkable deposit ratio. (5 points)

The lower currency-checkable deposit ratio will increase the money multiplier, thus increasing the money supply for a given monetary base. The purchase of bonds by the Fed will increase the monetary base, thus increasing the money supply for a given money muletiplier. Therefore, the net effect is an increase in the money supply.


(b) Predict what will happen to the money supply if a bank panic starts. Point out all of the steps (5 points)

The increase in bank panics would decrease the expected return on checkable deposits. The decreased expected return on checkable deposits would lead to an increase in the currency-checkable deposits ratio. This would cause a decrease in the money multiplier and thus the money supply.

The increase in bank panics would also increase expected deposit outflows and thus increase the expected return on excess reserves. The increased expected return on excess reserves would lead to increased holdings of excess reserves and thus a further decrease in the money supply.


(c) If the Fed sells a bank a $75 million of government securities and the non-bank public deposits $50 million of currency in the bank, what will happen to reserves, currency in circulation, and the monetary base? Explain your answer with all the appropriate T-accounts. (5 points)

T-accounts showing:

Reserves: -$25 million
Currency in Circulation: -$50 million
Monetary Base: -$75 million



3. Answer the following four questions regarding the simple model of deposit expansion.

(a) What the 2 problems with the simple model of deposit expansion? (2 points)

The model does not allow for the existence of currency or the holding of excess reserves by banks.

(b) What is the direction of bias in the simple model? (2 points)

The model overstates changes in the money supply.


(c) Under the simple model of deposit creation who controls the money supply and why? (3 points)

The simple model implies that the Fed has complete control over the money supply. This is because the Fed controls the required reserve ratio on checkable deposits (rr_c) and total reserves in the banking system (R), the two independent variables in the model.


(d) Under the more realistic model of money supply who controls the money supply and why? (3 points)

In the realistic model, the Fed, the banks, and the public jointly control the money supply. This because the public controls C/D, banks control ER and DL (somewhat), and the Fed controls rr_c and B_non.