Department of Economics
Spring 2003
Economics 353: Section 2
Money, Banking and Financial Institutions
Name: __________________________
Student ID number: ___ ___ ___ ___ (last 4 digits)
EACH
MULTIPLE-CHOICE QUESTIONS IS WORTH 1.5 POINTS: TOTAL 45 POINTS
EXAM 2: VERSION
A
March 13,
2003
PART ONE: Multiple-Choice Questions
1) When bonds become less widely traded, and as a consequence
the market becomes less liquid, the demand curve for bonds shifts to the
_____ and the interest rate _____.
A) right; rises B) right; falls
C) left; falls D) left;
rises
2) When the interest rate is above 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
3) When the price level rises, the demand curve for money
shifts to the _____ and the interest rate _____.
A) right; rises B) right; falls C) left; falls D) left; rises
4) When the Fed _____ the money stock, the money supply
curve shifts to the _____ and the interest rate _____.
A) decreases; right; rises
B) increases; right; falls
C) decreases; left; falls
D) increases; left; rises
E) decreases; right; falls
5) Holding the expected return on bonds constant, a decrease
in the expected return on stocks would _____ the demand for bonds, shifting
the demand curve to the _____.
A) decrease; left B) decrease;
right C) increase; left D) increase; right
6) In Keynes's liquidity preference framework, individuals
are assumed to hold their wealth in two forms:
A) real assets and financial assets.
B) stocks and bonds.
C) money and bonds. D) money and gold.
7) A higher level of income causes the demand for money
to _____ and the demand curve for money to shift to the _____.
A) decrease; right
B) decrease; left C)
increase; right D) increase; left
8) A decline in the expected inflation rate causes the
demand for money to _____ and the demand curve to shift to the _____.
A) decrease; right
B) decrease; left C) increase; right D) increase; left
9) When the inflation rate is expected to increase, the
real cost of borrowing declines at any given interest rate; the _____ of
bonds increases and the _____ curve shifts to the right.
A) demand, demand
B) demand, supply
C) supply, demand
D) supply, supply
10) When the inflation rate is expected to rise, interest
rates will _____; this result has been termed the _____.
A) fall, Keynes effect
B) fall, Fisher effect
C) rise, Pigou effect
D) rise, Fisher effect
E) rise, Keynes effect
11) In his Liquidity Preference Framework, Keynes assumed
that money has a zero rate of return; thus,
A) when interest rates rise, the expected return on money
falls relative to the expected return on bonds, causing the demand for money
to fall.
B) when interest rates rise, the expected return on money
falls relative to the expected return on bonds, causing the demand for money
to rise.
C) when interest rates fall, the expected return on money
falls relative to the expected return on bonds, causing the demand for money
to fall.
D) when interest rates fall, the expected return on money
falls relative to the expected return on bonds, causing the demand for money
to rise.
12) The term structure of interest rates is
A) the relationship among interest rates of different
bonds with the same maturity.
B) the structure of how interest rates move over time.
C) the relationship among the term to maturity of different
bonds.
D) the relationship among interest rates on bonds with
different maturities.
13) When the default risk in corporate bonds decreases, other
things equal, the demand curve for corporate bonds shifts to the _____ and
the demand curve for Treasury bonds shifts to the _____.
A) right; right B) right;
left C) left; left D) left;
right
14) The risk premium on corporate bonds rises when
A) brokerage commissions fall in the corporate bond market.
B) a flurry of major corporate bankruptcies occurs.
C) the Treasury bond market becomes less liquid.
D) any of the above occurs.
15) The interest rate on municipal bonds falls relative to
the interest rate on Treasury securities when
A) there is a major default in the municipal bond market.
B) income tax rates are raised.
C) municipal bonds become less widely traded.
D) corporate bonds become riskier.
E) none of the above occurs.
16) If the expected path of one-year interest rates over the
next five years is 4 percent, 5 percent, 7 percent, 8 percent, and 6 percent,
then the expectations theory predicts that today's interest rate on the five-year
bond is
A) 4 percent. B) 5 percent. C) 6
percent. D) 7 percent. E) 8
percent.
17) Interest rates on bonds of the same maturity will differ
because of differences in
A) liquidity.
B) risk.
C) income tax treatment.
D) all of the above.
E) only (a) and (b) of the above.
18) The theory of asset demand predicts that a decline in the
expected return on corporate bonds due to a rise in relative riskiness causes
A) a decline in the demand for default-free bonds.
B) an increase in the demand of corporate bonds.
C) a decline in the demand for corporate bonds.
D) a decline in the supply of corporate bonds.
19) According to the segmented markets theory of the term
structure
A) the interest rate for each maturity bond is determined
by supply and demand for that maturity bond.
B) bonds of one maturity are not substitutes for bonds
of other maturities, therefore, interest rates on bonds of different maturities
do not move together over time.
C) investors' strong preferences for short-term relative
to long-term bonds explain why yield curves typically slope upward.
D) all of the above.
E) none of the above.
20) When the yield curve is upward sloping,
A) the expectations theory suggests that short-term interest
rates are expected to rise.
B) the expectations theory suggests that short-term interest
rates are expected to fall.
C) the segmented markets theory suggests that short-term
interest rates are expected to fall.
D) the liquidity premium theory suggests that short-term
interest rates are expected to fall.
21) According to the law of one price, if the price of Colombian
coffee is 100 Colombian pesos per pound and the price of Brazilian coffee
is 4 Brazilian reals per pound, then the exchange rate between the Colombian
peso and the Brazilian reals is:
A) 40 pesos per
real.
B) 100 pesos per
real.
C) 25 pesos per
real.
D) 0.4 pesos per
real.
E) none of the above.
22) If the 2001 inflation rate in
A) rise by 5 percent. B) rise
by 2 percent. C) fall by 5 percent. D) fall by 2 percent.
E) do none of the above.
23) If, in retaliation for "unfair" trade practices, Congress
imposes a 30 percent tariff on Japanese videocassette recorders, but at the
same time, U.S. demand for Japanese goods increases, then, in the long run,
A) the Japanese yen should appreciate relative to the
dollar.
B) the Japanese yen should depreciate relative to the
dollar.
C) the dollar should depreciate relative to the yen.
D) it is not clear whether the dollar should appreciate
or depreciate relative to the yen.
24) If the Brazilian demand for American exports rises
at the same time that U.S. productivity rises relative to Brazilian productivity,
then, in the long run,
A) the Brazilian real should depreciate relative to the
dollar.
B) the Brazilian real should appreciate relative to the
dollar.
C) the dollar should depreciate relative to the Brazilian
real.
D) both (a) and (c) will occur.
E) it is not clear whether the Brazilian real should appreciate
or depreciate relative to the dollar.
25) If the interest rate is 7 percent on euro-denominated assets
and 5 percent on dollar-denominated assets, and if the dollar is expected
to appreciate at a 4 percent rate,
A) the expected return on euro-denominated assets in dollars
is 1 percent.
B) the expected return on dollar-denominated assets in
euros is 1 percent.
C) the expected return on euro-denominated assets in dollars
is 3 percent.
D) the expected return on dollar-denominated assets in
euros is 3 percent.
26) According to the interest parity condition, if the domestic
interest rate is 10 percent and the foreign interest rate is 12 percent,
then
A) the expected appreciation of the foreign currency must
be 4 percent.
B) the expected appreciation of the foreign currency must
be 2 percent.
C) the expected depreciation of the foreign currency must
be 2 percent.
D) the expected depreciation of the foreign currency must
be 4 percent.
27) The theory of asset demand suggests that the most important
factor affecting the demand for domestic and foreign deposits is the
A) productivity of the domestic country relative to the
foreign country.
B) price level of the domestic country relative to the
foreign country.
C) preference for domestic goods relative to foreign goods.
D) expected return on these assets relative to one another.
28) The expected return on dollar deposits in terms of dollars,
RETD, is
A) always the interest rate on dollar deposits, iD,
for any exchange rate.
B) the interest rate on dollar deposits, iD,
only when Et > Eet+1.
C) the interest rate on dollar deposits, iD,
only when Et < Eet+1.
D) the interest rate on dollar deposits, iD,
only when Et = Eet+1
29) If the central bank decides to _____ the level of the
money supply, the price level will rise in the long run, thereby reducing
the expected future exchange rate resulting in a _____ shift of RETF.
A) increase, rightward B) decrease, rightward
C) increase, leftward
D) decrease, leftward
30) Money neutrality means that in the _____ run the domestic
interest rate and RETD remain unchanged, implying that the fall
in the exchange rate is _____ in the short run than in the long run, a phenomenon
called exchange rate overshooting.
A) long, smaller B) long,
greater C) short, smaller D) short, greater
EXAM 2: VERSION
B
PART ONE: Multiple-Choice Questions
1) According to the law of one price, if the price of Colombian
coffee is 100 Colombian pesos per pound and the price of Brazilian coffee
is 4 Brazilian reals per pound, then the exchange
rate between the Colombian peso and the Brazilian reals
is:
A) 40 pesos per
real.
B) 100 pesos per
real.
C) 25 pesos per
real.
D) 0.4 pesos per
real.
E) none of the above.
2) If the 2001 inflation rate in
A) rise by 5 percent.
B) rise by 2 percent.
C) fall by 5 percent.
D) fall by 2 percent.
E) do none of the above.
3) If, in retaliation for "unfair" trade practices, Congress
imposes a 30 percent tariff on Japanese videocassette recorders, but at the
same time, U.S. demand for Japanese goods increases, then, in the long run,
A) the Japanese yen should appreciate relative to the
dollar.
B) the Japanese yen should depreciate relative to the
dollar.
C) the dollar should depreciate relative to the yen.
D) it is not clear whether the dollar should appreciate
or depreciate relative to the yen.
4) If the Brazilian demand for American exports rises at
the same time that U.S. productivity rises relative to Brazilian productivity,
then, in the long run,
A) the Brazilian real should depreciate relative to the
dollar.
B) the Brazilian real should appreciate relative to the
dollar.
C) the dollar should depreciate relative to the Brazilian
real.
D) both (a) and (c) will occur.
E) it is not clear whether the Brazilian real should appreciate
or depreciate relative to the dollar.
5) If the interest rate is 7 percent on euro-denominated
assets and 5 percent on dollar-denominated assets, and if the dollar is expected
to appreciate at a 4 percent rate,
A) the expected return on euro-denominated assets in dollars
is 1 percent.
B) the expected return on dollar-denominated assets in
euros is 1 percent.
C) the expected return on euro-denominated assets in dollars
is 3 percent.
D) the expected return on dollar-denominated assets in
euros is 3 percent.
6) According to the interest parity condition, if the domestic
interest rate is 10 percent and the foreign interest rate is 12 percent,
then
A) the expected appreciation of the foreign currency must
be 4 percent.
B) the expected appreciation of the foreign currency must
be 2 percent.
C) the expected depreciation of the foreign currency must
be 2 percent.
D) the expected depreciation of the foreign currency must
be 4 percent.
7) The theory of asset demand suggests that the most
important factor affecting the demand for domestic and foreign deposits is
the
A) productivity of the domestic country relative to the
foreign country.
B) price level of the domestic country relative to the
foreign country.
C) preference for domestic goods relative to foreign goods.
D) expected return on these assets relative to one another.
8) The expected return on dollar deposits in terms of
dollars, RETD, is
A) always the interest rate on dollar deposits, iD, for any exchange rate.
B) the interest rate on dollar deposits, iD, only when Et > Eet+1.
C) the interest rate on dollar deposits, iD, only when Et < Eet+1.
D) the interest rate on dollar deposits, iD, only when Et = Eet+1
9) If the central bank decides to _____ the level of
the money supply, the price level will rise in the long run, thereby reducing
the expected future exchange rate resulting in a _____ shift of RETF.
A) increase, rightward
B) decrease, rightward
C) increase, leftward
D) decrease, leftward
10) Money neutrality means that in the _____ run the domestic
interest rate and RETD remain unchanged, implying that the fall
in the exchange rate is _____ in the short run than in the long run, a phenomenon
called exchange rate overshooting.
A) long, smaller B) long,
greater C) short, smaller D) short, greater
11) The term structure of interest rates is
A) the relationship among interest rates of different
bonds with the same maturity.
B) the structure of how interest rates move over time.
C) the relationship among the term to maturity of different
bonds.
D) the relationship among interest rates on bonds with
different maturities.
12) When the default risk in corporate bonds decreases, other
things equal, the demand curve for corporate bonds shifts to the _____ and
the demand curve for Treasury bonds shifts to the _____.
A) right; right B) right;
left C) left; left D) left;
right
13) The risk premium on corporate bonds rises when
A) brokerage commissions fall in the corporate bond market.
B) a flurry of major corporate bankruptcies occurs.
C) the Treasury bond market becomes less liquid.
D) any of the above occurs.
14) The interest rate on municipal bonds falls relative to
the interest rate on Treasury securities when
A) there is a major default in the municipal bond market.
B) income tax rates are raised.
C) municipal bonds become less widely traded.
D) corporate bonds become riskier.
E) none of the above occurs.
15) If the expected path of one-year interest rates over the
next five years is 4 percent, 5 percent, 7 percent, 8 percent, and 6 percent,
then the expectations theory predicts that today's interest rate on the five-year
bond is
A) 4 percent. B) 5 percent. C) 6 percent.
D) 7 percent. E) 8 percent.
16) Interest rates on bonds of the same maturity will differ
because of differences in
A) liquidity.
B) risk.
C) income tax treatment.
D) all of the above.
E) only (a) and (b) of the above.
17) The theory of asset demand predicts that a decline in the
expected return on corporate bonds due to a rise in relative riskiness causes
A) a decline in the demand for default-free bonds.
B) an increase in the demand of corporate bonds.
C) a decline in the demand for corporate bonds.
D) a decline in the supply of corporate bonds.
18) According to the segmented markets theory of the term
structure
A) the interest rate for each maturity bond is determined
by supply and demand for that maturity bond.
B) bonds of one maturity are not substitutes for bonds
of other maturities, therefore, interest rates on bonds of different maturities
do not move together over time.
C) investors' strong preferences for short-term relative
to long-term bonds explain why yield curves typically slope upward.
D) all of the above.
E) none of the above.
19) When the yield curve is upward sloping,
A) the expectations theory suggests that short-term interest
rates are expected to rise.
B) the expectations theory suggests that short-term interest
rates are expected to fall.
C) the segmented markets theory suggests that short-term
interest rates are expected to fall.
D) the liquidity premium
theory suggests that short-term interest rates are expected to fall.
20) When bonds become less widely traded, and as a consequence
the market becomes less liquid, the demand curve for bonds shifts to the
_____ and the interest rate _____.
A) right; rises B) right; falls
C) left; falls D) left;
rises
21) When the interest rate is above 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
22) When the price level rises, the demand curve for money
shifts to the _____ and the interest rate _____.
A) right; rises B) right; falls C) left; falls D) left; rises
23) When the Fed _____ the money stock, the money supply curve
shifts to the _____ and the interest rate _____.
A) decreases; right; rises
B) increases; right; falls
C) decreases; left; falls
D) increases; left; rises
E) decreases; right; falls
24) Holding the expected return on bonds constant, a decrease
in the expected return on stocks would _____ the demand for bonds, shifting
the demand curve to the _____.
A) decrease; left B) decrease;
right C) increase; left D) increase;
right
25) In Keynes's liquidity preference framework, individuals
are assumed to hold their wealth in two forms:
A) real assets and financial assets.
B) stocks and bonds.
C) money and bonds. D) money and gold.
26) A higher level of income causes the demand for money
to _____ and the demand curve for money to shift to the _____.
A) decrease; right
B) decrease; left C) increase;
right D) increase; left
27) A decline in the expected inflation rate causes the
demand for money to _____ and the demand curve to shift to the _____.
A) decrease; right
B) decrease; left C)
increase; right D) increase; left
28) When the inflation rate is expected to increase, the
real cost of borrowing declines at any given interest rate; the _____ of
bonds increases and the _____ curve shifts to the right.
A) demand, demand
B) demand, supply
C) supply, demand
D) supply, supply
29) When the inflation rate is expected to rise, interest
rates will _____; this result has been termed the _____.
A) fall, Keynes effect
B) fall, Fisher effect
C) rise, Pigou effect
D) rise, Fisher effect
E) rise, Keynes effect
30) In his Liquidity Preference Framework, Keynes assumed
that money has a zero rate of return; thus,
A) when interest rates rise, the expected return on money
falls relative to the expected return on bonds, causing the demand for money
to fall.
B) when interest rates rise, the expected return on money
falls relative to the expected return on bonds, causing the demand for money
to rise.
C) when interest rates fall, the expected return on money
falls relative to the expected return on bonds, causing the demand for money
to fall.
D) when interest rates fall, the expected return on money
falls relative to the expected return on bonds, causing the demand for money
to rise.
PART TWO: Problems TOTAL 55 POINTS
Question 1:
a) List the four effects on interest rates resulting from a rise in the money supply.
(i) Liquidity effect
(ii) Income effect
(iii) Price-level effect
(iv) Expected-inflation effect
b) Show how each effect changes the equilibrium interest rate.
[NOTE: If you show your answers graphically, you will receive extra credit. You can show the changes in interest rates using the loanable funds framework (shifts in the supply of and/or demand for bonds) and/or the liquidity preference framework (shifts in the supply of and/or demand for money).]
(i)
The liquidity effect: An
increase in the money supply leads to a decrease in the interest
rate. You can show this graphically by shifting
the money supply to the right as in Figure 12 on page 119 of your textbook.
(ii) The income effect: An increase in the money supply leads to an increase in the interest rate. Since an increase in the money supply has an expansionary effect which raises national income, the demand for money increases. You can show this increase in interest rates by shifting the money demand curve to the right as in Figure 11 on page 119 of your textbook.
Note: You can also show an increase in income causing an increase in the interest rate using the loanable funds framework by shifting the demand for bonds curve to the right (as wealth/income increases you demand more assets) and shifting the supply of bonds curve to the right (as more profitable investment opportunities arise) as in Figure 7 on page 109 of your textbook.
iii) Price-level effect: An increase in the money supply leads to an increase in the interest rate. Since an increase in the money supply causes an increase in the overall price level in the economy, the demand for money increases. You can show this increase in interest rates by shifting the money demand curve to the right as in Figure 11 on page 119 of your textbook.
(iv) Expected-inflation effect: An increase in the money supply leads to
an increase in the interest rate. Since
an increase in the money supply causes an increase in the expected inflation,
the demand for bonds decreases (price/value of real assets expected to go
up so expected return on bonds relative to real assets falls) and the supply
of bonds increases (as the real cost of borrowing goes down). You can show
this increase in interest rates by shifting the demand for bonds curve to
the left and the supply of bond curve to the right as in Figure 5 on page
107 of your textbook.
c) Describe and graph the three scenarios of the response of interest rates over time to an increase in the rate of money supply growth.
The three scenarios are:
a) the liquidity effect is larger than the income effect, the price-level effect and the expected-inflation effect (so increase in money supply leads to fall in interest rates)
b) the liquidity effect is smaller than the other three effects and there is slow adjustment of expected inflation (so increase in money supply leads to rise in interest rates)
c) the liquidity effect is smaller than the expected-inflation effect and there is rapid adjustment of expected inflation (so increase in money supply leads to rise in interest rates)
The graphs are shown in Figure 13 on page 123 of your textbook.
NOTE: The liquidity effect from an increase in the money growth rate takes effect immediately (increase in money supply leads to fall in interest rates) whereas the income and price-level effects take time to work. The expected-inflation effect can be slow or fast depending on whether people adjust their expectations of inflation slowly or quickly when there is an increase in the money growth rate.
d) Which scenario is supported by evidence?
Scenario (b): where an increase in the money growth lowers short-term interest rates temporarily. In the long run, interest rates end up higher than the initial interest rate.
e) Why is it important for the Fed and policymakers to know which one of these three scenarios is closest to reality when deciding to decrease interest rates?
The scenario determines whether the Fed should increase or decrease the money supply growth to decrease interest rates.
If the liquidity effect is dominant (scenario a) then an increase in money supply growth is required to decrease interest rates.
If the liquidity effect is smaller and there is rapid adjustment of the expected inflation rate (scenario c), then a decrease in money supply growth is required to decrease interest rates.
If the liquidity effect
is smaller and there is slow adjustment of the expected inflation rate (scenario
b), then an increase in money supply growth reduces interest rates in the
short run and a decrease in money supply growth reduces interest rates in
the long run. So it depends on whether the Fed cares
more about what happens in the short run or the long run.
Question 2:
a)
Write the equation that represents the liquidity
premium theory of the term structure. Please define
your terms clearly.
is the interest rate on an n-period bond
is today’s (time t) interest rate on a one-period bond
is the interest rate on
a one-period bond expected for next period (time t+1)
is the liquidity (term) premium
for the n-period bond at time t
n is the term to maturity of the bond
b) According to the liquidity premium theory, what do the following imply about the expectations of future short-term interest rates: (Please draw and label your graph for each case clearly.)
The graphs for each case can be found on page 146 of your textbook.
(i) steep upward slope of the yield curve
Future
short-term interest rates are expected to rise.
(ii) mild upward slope of the yield curve
Future short-term interest rates are expected to stay the same (or are not expected to rise or fall much in the future).
(iii) flat slope of the yield curve
Future
short-term interest rates are expected to fall moderately.
(iv) inverted slope of the yield curve
Future
short-term interest rates are expected to fall sharply.
Question 3:
a) Why are movements in the exchange rate better explained by movements in real interest rates rather than nominal interest rates?
Looking at just nominal interest rates, we cannot determine whether the dollar will appreciate or depreciate when nominal interest rates rise. A rise in nominal interest rates may be due to a rise in real interest rates, which would result in the dollar appreciating, but a rise in nominal interest rates may also be due to a rise in expected inflation, which would result in the dollar depreciating.
NOTE: Remember that according to the Fisher equation, the nominal interest rate is equal to the real interest rate plus expected inflation (i = ir + pe).
b) Given the following scenarios, show what happens to the exchange rate in each case using the schedules for the expected return on dollar-denominated deposits (RETD) and the expected return on foreign-denominated deposits (RETF):
(i) higher interest rate outlook in Euro area
(ii)
announcement of higher wages in
(iii) Fall in the price of U.S. Treasurys resulting from inflation fears
(iv) Outlook for strong Euro-zone growth
For extra credit: (5 points)
(v)
Talk of G-7 intervention to weaken the
yen
These scenarios have
been taken from “Following the Financial News” section on page 176 of your
textbook.
(i) higher interest
rate outlook in the Euro area: The interest rate on euro-denominated
(foreign) deposits (iF) has increased which means that the expected
return on these deposits (
)
goes up. This leads to a rightward shift in the
expected-return schedule of the euro-deposits from
to
as in Figure 4 on page 166 of your textbook. The result
is a decrease in the exchange rate (the domestic currency, the dollar,
depreciates while the foreign currency, the euro, appreciates).
(ii) announcement of higher wages in
). So the
curve
shifts to the left, resulting in an increase in the exchange rate,
i.e., an appreciation of the dollar and a depreciation of the euro (the
opposite of Figure 4 on page 166 of your textbook).
(iii) fall in the price of
curve
shifts to the right, which causes the exchange rate to fall (i.e.,
the dollar to depreciate and the euro to appreciate).
(iv) outlook for strong Euro-zone growth: This
indicates that the value of the euro is likely to be higher in the future
and so, the expected return on euro deposits will be higher. This will result in a shift in the
curve
to the right and a depreciation of the dollar (appreciation of the euro).
Extra credit:
(v)
talk of G-7 intervention to weaken the
yen: This may lead to the decline of the yen in the future which would
decrease the expected return on foreign (yen) deposits. The
curve
will shift to the left resulting in the appreciation of the dollar (depreciation
of the yen).