Money and Banking HW Questions
After careful analysis, you have determined that a firm's dividends should grow at 7%, on average, in the foreseeable future. The firm's last dividend was $3. Compute the current price of this stock, assuming the required return is 18%.
1 x .07 = 1.07 ........ 3 x 1.07 / 0.18 - 0.07 = 29.18
compute the price of a share of stock that pays a $1 per year dividend and that you expect to be able to sell in one year for $20, assuming you require a 15% return.
1 x .15 = 1.15 ....... 1 / 1.15 + 20 / 1.15 = 18.26
assuming the expectations theory is the correct theory of the term structure, calculate the interest rates in the term structure for maturities of one to five years, and plot the resulting yield curves for the following paths of one-year interest rates over the next five years: 5%, 4%, 3%, 4%, 5%
1 year bond: 5% 2 year bond: 4.5% 3 year bond: 4% 4 year bond: 4% 5 year bond: 4.2% the yield curve is downward and then upward sloping. if people prefer shorter-term bonds over longer-term bonds, the yield curve would be more upward sloping.
assuming the expectations theory is the correct theory of the term structure, calculate the interest rates in the term structure for maturities of one to five years, and plot the resulting yield curves for the following paths of one-year interest rates over the next five years: 5%, 6%, 7%, 6%, 5%
1 year bond: 5% 2 year bond: 5.5% 3 year bond: 6% 4 year bond: 6% 5 year bond: 5.8% the yield curve is upward and then downward sloping. if people prefer shorter-term bonds over longer-term bonds, the yield curve would be more upward sloping
if the interest rate is 10%, what is the present value of a security that pays you $1,100 next year, $1,210 the year after, and $1,331 the year after that?
1100 / 1+10% + 1210 / (1+10%)^2 + 1331 / (1+10%)^3 = 3000
would a dollar tomorrow be worth more to you today when the interest rate is 20% or when it is 10%?
a dollar will be worth (1+20%) = $0.83 when the interest rate is 20%. it would be worth (1+10%) = $0.91 when the interest rate is 10%. so the dollar is worth more when the interest rate is 10%.
identity
a relationship that is true by definition
if the income tax exemption on municipal bonds were abolished, what would happen to the interest rates on these bonds? what effect would the change have on interest rates on US Treasury securities?
abolishing the tax-exempt feature of municipal bonds would make them less desirable relative to T-bonds. The decline in the demand for municipal bonds and the increase in demand for T-bonds would raise the interest rates on municipal bonds, while the interest rates on T-bonds would fall.
present value
aka present discounted value. a dollar today is worth more than a dollar tomorrow. future cash flows are discounted
how is an autonomous tightening or easing of monetary policy different from a change in the real interest rate caused by a change in the current inflation rate?
an autonomous tightening or easing of the monetary policy occurs when there is some change to the outlook of the economy or financial markets. this change in stance in monetary policy is independent from the current inflation rate
what would be the effect of an increase in U.S. net exports on the aggregate demand curve? would an increase in net exports affect the monetary policy curve? explain
an increase in U.S. net exports shifts the IS curve to the right, increasing aggregate output at every real interest rate level. it does not affect the MP curve
suppose that government spending increases at the same time with an autonomous easing of monetary policy. what happens to AD? explain with a few sentences.
an increase in government spending shifts IS to the right (output is higher at every real interest rate level). an easing of monetary policy shifts MP to the right (real interest rate is lower at every inflation rate level). AD will shift to the right a lot because both shifts will cause the AD to shift to the right.
use the market of reserve to show the effect of an open market purchase. is there a scenario where this monetary policy is not effective?
an open market purchase can shift NBR to the right and decrease the federal funds rate. when i^ff is already low and is bounded by interest on reserve, i^or, the operation is not going to be effective
in the market for reserve --> explain with a few sentences why the following statement is true: Rd is downward sloping when the federal funds rate is higher than the interest rate paid on reserve
as the cost of borrowing decreases, the opportunity cost of keeping excess reserve at the central bank decreases, so quantity demanded of reserve increases
in 2010 and 2011, the government of Greece risked defaulting on its debt due to a severe budget crisis. using bond market graphs, compare the effects on the risk premium between US Treasury debt and comparable-maturity Greek debt.
as the risk of default by the Greek government increased, Greek bonds are less desirable relative to US Treasuries. this reduced the demand for Greek bonds. the result is that the risk premium between Greek debt an US debt would increase. the situation is similar to Figure 2 (pg. 119) in the textbook
due to the global financial crisis, demand for goods and services decreased in most countries. in a country that relies on export, soon after the financial crisis, the appropriate monetary policy took place. we observe the following: step 1: inflation decreases and the unemployment rate increases step 2: inflation increases and the unemployment rate decreases what is the appropriate monetary policy here? explain why we observe the above using the graph of aggregate demand and aggregate supply analysis and use a few sentences to describe what happened.
assume the economy was at long-run equilibrium before the financial crisis. as global demand for goods and service decreases, NX decreases, which leads IS and AD to shift to the left. in the AS-AD model, it results in a short-run equilibrium with lower inflation and lower output (thus higher unemployment rate), creating a negative output gap. this explains the observation in step 1. the appropriate monetary policy here would be to stabilize inflation as the change in AD happens, so the central bank should choose the easing of monetary policy which shift AD to the right through shifting MP to the right. This monetary policy will reverse as the effect from step 1, thus the observation in step 2.
what will happen in the bond market to the demand for bonds if the government imposes a limit on the amount of daily transactions? which characteristic of an asset would be affected?
bonds will become less liquid with respect to alternative assets
list two reasons why commercial banks might have an excess reserve
commercial banks might have excess reserve because 1) they need buffer to avoid borrowing reserve from the Fed when their deposit levels fluctuate; 2) keeping reserve with the central bank becomes a better option than loaning it out in the market because of low return or risk factors
explain how the following event will effect the demand for money according to the portfolio theory: the stock market is predicted to do well in the near future
demand for money decreases as the expected return of stock increases
explain how the following event will effect the demand for money according to the portfolio theory: the economy experiences a boom
demand for money increases as people are wealthier
explain how the following event will effect the demand for money according to the portfolio theory: brokerage fees increase, making bond transactions more expensive
demand for money increases as the expected return of bond decreases
risk premiums on corporate bonds are usually anti cyclical; that is, they decrease during business cycle expansions and increase during recessions. why is this so?
during economic booms, fewer corporations go bankrupt and there is less default risk on corporate bonds, which lowers their risk premium. During recessions, default risk on corporate bonds increases and their risk premium increases. so the risk premium on corporate bonds in thus anti cyclical: rising during recessions and falling during booms.
use words to explain the difference between expected inflation and the inflation shock
expected inflation is formed through observations of historical inflation values and predicted effects of events that are expected to happen. p is price shock caused by events that drive up the cost of production unexpectedly. both affect the inflation directly and shift the AS curve since expected inflation depends on historical values which depend on historical values in output gap, which is another factor that shifts AS. this means that when there is an output gap, expected inflation will be updated in a way that pushes AS in the same direction as the output gap does.
Raphael observes that at the current level of interest rates there is an excess supply of bonds, and therefore he anticipates an increase in the price of bonds. is Raphael correct?
he is incorrect. if there is an excess supply of bonds, quantity supplied is higher than quantity demanded and the price is higher than the equilibrium price. in order to reach the equilibrium, the price will decrease and the interest rate will increase.
if upside down y = 0, what does this imply about the relationship between the nominal interest rate and the inflation rate?
if upside down y = 0, then real interest rate is not going to change when inflation changes. In other words, real interest rate will remain constantly at the level of the autonomous real interest rate, r (with line over top). since i = r - pie , when r is constant, nominal interest rate will increase/decrease the exact same amount as inflation rate when inflation rate increases/decreases.
if velocity and aggregate real output are reasonably constant, what happens to the price level when the money supply increases from $2 trillion to $6 trillion?
if velocity and aggregate real output are reasonably constant, P x Y(autonomous) = M x V(autonomous) price level changes proportionally to the change in money supply. since money supply increases 3 times (from $2 trillion to $6 trillion), the price level will increase 3 times
if yield curves, on average, were flat, what would this say about the liquidity (term) premiums in the term structure? would you be more or less willing to accept the expectations theory?
if yield curves on average were flat, the risk premium on long-term relative to short-term bonds is 0. we would be more willing to accept the expectation theory
"if the Fed increases the discount rate, it may or may not increase the Federal Funds rates." Is this statement correct? Why or why not? Use graphs and a few sentences to explain.
is it correct. changing the discount rate would only change the federal funds rate when the federal funds rate is high and equal to the discount rate. the graphs below describe the two scenarios: the federal funds rate on the left does not change and it does change on the right.
marginal propensity to consume is higher for people with lower income levels because they spend a higher fraction of their disposable income. if the government would like to stimulate growth (increase output) through a tax cut, which tax cut would be more effective, a tax cut for the rich or the poor?
it would be more effective to cut tax on the poor because their mpc is higher, which means a higher fraction of the cut will be spent in consumption, increasing output
explain why you would be more or less willing to buy long-term AT&T bonds under the following circumstance: you expect interest rates to rise
less, because as interest rate increases, future prices will fall and expected return is lower
explain why you would be more or less willing to buy long-term AT&T bonds under the following circumstance: brokerage commissions on stocks fall
less, because the bonds are now less liquid relative to stock, an alternative asset
consider a coupon bond that has a $1,000 par value and a coupon rate of 10%. the bond is currently selling for $1,044.89 and has two years to maturity. what is the bond's yield to maturity?
let i be the yield to maturity. the price is equal to the present value: 1044.89 = 1,000 x 10% / 1+i + 1,000 x 10% / (1+i)^2 + 1,000 / (1+i)^2 the first two are coupon payments and the third is the final payment of the face value
identify which function of money is emphasized brooke accepts money in exchange for performing her daily tasks at her office, since she knows she can use that money to buy goods and services
medium of exchange, which refers to the ability of money to facilitate trades in a society
in a fractional reserve system with a required reserve ratio of 20% , the central bank increases the money supply by $200. what would be the change to money supply in this economy? be explicit about the direction of the change and show work.
money supply would increase by 200 / 0.2 = 1000
explain why you would be more or less willing to buy long-term AT&T bonds under the following circumstance: brokerage commissions on bonds fall
more, because the bonds are now more liquid
explain why you would be more or less willing to buy long-term AT&T bonds under the following circumstance: trading in these bonds increases, making them easier to sell
more, because the bonds are now more liquid
explain why you would be more or less willing to buy long-term AT&T bonds under the following circumstance: you expect a bear market in stocks (stock prices are expected to decline)
more, because the expected return of bonds increases relative to stocks, an alternative asset
in the following case, determine whether the IS curve shifts to the right or the left, does not shift, or is indeterminate in the direction of shift. the real interest rate rises
moves along the IS curve. real interest rate increases and output decreases
dividend
payments made periodically (usually every quarter) to shareholders
Based on the Quantity Theory, inflation equals the growth rate of the money supply minus the growth rate of real output. If the aggregate output grows at 3% a year and the central bank increases the money supply by 5%, what is the inflation rate in this economy?
pie (inflation) = % growth rate P = % growth rate M - % growth rate Y 5% - 3% = 2%
in the market for reserve --> explain with a few sentences why the following statement is true: Rs is vertical when the federal funds rate is lower than the discount rate
quantity of non-borrowed reserve does not change as federal funds rate changes
why is paying interest on excess reserve NOT a conventional monetary policy that central banks use? use graphs and a few sentences to explain.
reserve is traditionally used to conduct open market operations to control money supply only and adjusting interest on reserve is not an option when the central bank does not pay interest on reserve. meanwhile, in normal times, adjusting interest on reserve may not be effective in changing the federal funds rate
in the following case, determine whether the IS curve shifts to the right or the left, does not shift, or is indeterminate in the direction of shift. autonomous consumption decreases
shifts IS to the left
in the following case, determine whether the IS curve shifts to the right or the left, does not shift, or is indeterminate in the direction of shift. financial frictions increase
shifts IS to the left
in the following case, determine whether the IS curve shifts to the right or the left, does not shift, or is indeterminate in the direction of shift. the marginal propensity to consume (mpc) declines
shifts IS to the left
in the following case, determine whether the IS curve shifts to the right or the left, does not shift, or is indeterminate in the direction of shift. the government provides tax incentives for research and development programs for firms
shifts IS to the right
in the following case, determine whether the IS curve shifts to the right or the left, does not shift, or is indeterminate in the direction of shift. the sensitivity of net exports to changes in the real interest rate decreases
shifts IS to the right
after years of recovering from the financial crisis, firms and people have recovered confidence in the future. the unemployment rate is at the natural rate of unemployment. in order to further decrease the unemployment rate, the government increases government spending and cuts tax. use the graphs of aggregate demand and aggregate supply to answer the following questions. 1) without any additional policy intervention, what would happen? 2) assume the central bank is not goal independent and the government asks the central bank to help with the easing of monetary policy. what would happen if the central bank agrees to do so?
since the unemployment rate has returned to the natural rate of unemployment, the economy has recovered and is currently at the long-run equilibrium. the increase in government spending and tax cut will shift AD to the right. -without policy intervention, it will increase inflation and output, creating a positive output gap. AS will respond to the output gap by shifting to the left, decreasing the output to the natural rate of output while further increasing inflation. -if the central bank is not goal independent, conducting the easing of monetary policy will shift AD further to the right, creating an even bigger output gap. The self-correcting process of AS will also increase inflation more, creating more drastic increases in inflation during the process. this is not ideal for economic stability.
identify which function of money is emphasized maria is currently pregnant. she expects her expenditures to increase in the future and decides to increase the balance in her savings account
store of value, maria stores the value of her income in this bank account for a period of time
list three ways that the Fed can decrease the money supply and briefly explain how they work
the Fed can: increase the required reserve ratio increase interest rate paid on reserve conduct open market sale (to decrease money supply)
money supply
the amount of money in the economy, determined by the central bank
velocity
the average number of times per year that a dollar is spent in buying goods and services produced in the economy
suppose that you want to take out a loan and that your local bank wants to charge you an annual real interest rate equal to 3%. Assuming that the annualized expected rate of inflation over the life of the bond is 1%, determine the nominal interest rate that the bank will charge you. what happens if, over the life of the loan, actual inflation is 0.5%.
the bank will charge you a nominal interest rate of 1% + 3% = 4%. if the actual inflation turns out to be 0.5%, lower than expected, you will be worse off than originally planned since the real cost of borrowing for you is now 4% - 0.5% = 3.5%. (recall: r = i + pie^e)
in the fractional reserve system, if the central bank wants to decrease the money supply by changing the required reserve ratio, what direction should the change be? briefly explain why
the central bank should increase the required reserve ratio to decrease money supply. money supply = base money / rr
A $1,000-face-value bond has a 10% coupon rate, its current price is $960, and its price is expected to increase to $980 next year. calculate the current yield, the expected rate of capital gain, and the expected rate of return.
the current yield = C / P^t 1000 x 10% / 960 = 10.4% the expected rate of capital gain = P^t+1 - P^t / P^t 980-960 / 960 = 2.1% the expected rate of return = i^c + g 10.4% + 2.1% = 12.5%
what will happen in the bond market to the demand for bonds if there is a sudden increase in people's expectations of future STOCK prices? which characteristic of an asset would be affected? (hint: think about how the price of an asset affects which characteristic of the asset in the portfolio theory)
the expected return of bonds is now lower with respect to alternative assets (stock)
a lottery claims its grand prize is $10 million, payable over 5 years at $2,000,000 per year. if the first payment is made immediately, what is the grand prize really worth? use an interest rate of 6%.
the present value of the lottery cash flow is.... 2,000,000 + 2,000,000 / 1+6% + 2,000,000 / (1+6%)^2 + 2,000,000 / (1+6%)^3 + 2,000,000 / (1+6%)^4
in the market for reserve --> explain with a few sentences why the following statement is true: Rd is not defined when the total reserve is lower than the required reserve
the required reserve is an agreed amount that banks cannot go below by definition
required return to equity
the yield YOU are satisfied with your investment, used to discount the cash flow from stock
there is a negative supply shock in the economy. some experts say it is a temporary shock and others believe it is a permanent shock. would they agree on the policies that should take place? why or why not? please include graphs of aggregate demand and aggregate supply to describe both scenarios.
they would not agree on the solution. a permanent negative supply shock means that both AS and LRAS will shift to the left and eventually, the long-run equilibrium will be at a lower level output and a higher level of unemployment rate. Here, policy should address the issue of continuous increase in price levels and decrease in output (or increase in unemployment rate). policy that can stabilize inflation should be considered. a temporary negative supply shock means that the LRAS will not change, and the economy will move back to the original long-run equilibrium through self-correction without policy intervention. here, policies may not be necessary if the temporary change will happen quickly and the magnitude is small.
"if f (friction and autonomous (line over the f)) increases, then the Fed can keep output constant by reducing the real interest rate by the same amount as the increase in financial frictions." is this statement true, false, or uncertain? explain your answer.
this statement is false. if real interest rate is reduced by the same amount as financial frictions increase, investment will not change because the two changes cancel out. however, real interest rate also affects net export. when real interest decreases, net export increases and the aggregate output will increase. if the Fed wants to keep output constant, it needs to reduce the real interest rate by a little bit less than the change in financial frictions.
"the Fed decreased the fed funds rate in late 2007, even though inflation was increasing. this action demonstrated a violation of the Taylor principle." is this statement true, false, or uncertain? explain your answer.
this statement is false. in this situation, the Fed reduced the federal funds rates as easing of the monetary policy. the adjustment was made to the autonomous real interest rate, r (with a line over it)
identify which function of money is emphasized tim wants to calculate the relative value of oranges and apples and therefore checks the price per pound of each of these goods as quoted in currency units
unit of account, the value of apples and oranges are being measured in currency units
use words to explain the concept of the money multiplier. why is it important?
when a deposit is made at a bank, a fraction will become reserve at the central bank and the rest will be made to the public as a loan, which becomes a deposit and goes into money supply. this money supply process through deposits and loans causes money supply to change at a magnitude that is larger than the change in base money. The money multiplier describes how much the money supply changes when the base money changes by $1. it is the inverse of the required reserve ratio.
in the market for reserve --> explain with a few sentences why the following statement is true: Rs is horizontal when the federal funds rate is higher than the discount rate
when borrowing from other commercial banks cost more than borrowing from the central bank, banks will always borrow from the central bank at the discount rate, resulting in borrowed reserve
in the market for reserve --> explain with a few sentences why the following statement is true: Rd is horizontal when the federal funds rate is lower than the interest rate paid on reserve
when interest paid on reserve is higher interest paid on bank overnight loans, banks will choose to keep excess reserve instead of giving overnight loans
when the stock market rises, what would happen to investment? explain your answer.
when the stock market rises, the expected return of stock increases and demand for bond decreases. this leads to a higher interest rate and investment decreases
do bondholders fare better when the yield to maturity increases or when it decreases? why?
when the yield to maturity increases, the price of the bond decrease. in other words, what the bondholder has is now worth less, so the bondholder is worse off. so bondholders are better off when yield to maturity decreases.
some economists suspect that one of the reasons economies in developing countries grow so slowly is that they do not have well-developed financial markets. Does this argument make sense?
yes, because the absence of the financial markets means that funds cannot be redistributed to the people who have the highest marginal product of capital. Entrepreneurs cannot acquire funds to set up businesses that would allow the economy to grow rapidly.
will there be an effect on interest rates if brokerage commissions on stocks fall? explain your answer.
yes. the interest rate is determined in the bonds market. the lower commission on stocks makes them more liquid relative to bonds, and the demand for bonds will fall. the demand curve B^d will shift to the left and the equilibrium interest rate will increase.
if the yield curve suddenly became steep, how would you revise your predictions of interest rates in the future?
you would raise the predictions of future interest rates, because higher long-term rates implies that the expected future short-term rates is higher
if you suspect that a company will go bankrupt next year, which would you rather hold, bonds issued by the company or equities issued by the company? Why?
you would rather hold bonds, because bondholders are paid off before equity holders, who are paid the residual.