ECO201 Principles of Macroeconomics FINAL
EXAM
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1. Suppose the CFO of an American corporation with surplus cash
flow had $100 million to invest last July 15 and the corporation did not
believe it would 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 was .5%, while the rate on 1 year CD deposits in England
(denominated in British Pounds) was 2% at the time. Suppose further
that the exchange rate at that time was $1.68 per British pound .
A) Suppose that now a year later the exchange rate is $1.55 per
US pound. What rate of return did the CFO earn on the investment in the British
CD? (Note: a specific numeric answer.)
B) What must the CFO have expected about the value of the
British pound in $ today to believe that investment in British CD’s was more
profitable than investment in US CD’s last July?
2. 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.
Explain why the Fed created all
these extraordinary direct lending facilities instead of simply relying on
traditional open market purchases of Treasury securities.
3. As conditions in short term financial markets improved by
summer of 2009 the Fed closed down its lending under these programs. However,
throughout the next 4 years the Fed increased substantially its purchases
of longer term mortgage backed securities and Treasury notes from banks in a
series of 3 “Quantitative Easing” (QE) Programs.
A)Assume that both lender & borrower confidence levels
start to return to normal and financial and physical investment levels start to
rise much more strongly in the next 12 months than in the last few years. What
potential problems will the extraordinary growth in banks’ reserve deposits and
in the size of the Fed’s portfolio of longer term Treasury and Mortgage backed
bonds that has resulted from 3 rounds of Quantitative Easing create then for
the Fed? 4pts
B) What relatively untested policy tools will help the Fed deal
with this problem? Explain.
4. In recent weeks markets
around the world have been rattled by signs of a slowdown in growth of
the Chinese economy, together with a massive sell–off in its stock market… plus
a massive default by Greece on its debts to the IMF , the ECB and on its
government bonds which will be averted only if it agrees to harsh budget
austerity measures imposed by Germany and the rest of the European Union…In the
process, the value of the $ has risen against the Euro, the Yuan and many other
currencies.
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
situation of the US economy.
Draw an AS/AD diagram to illustrate your answer. Clearly label
axes and the current position of AS, & AD relative to full employment
RGDP….also indicate any shifts that would occur if the exchange rate of the $ rose
sharply against other major currencies
5. Current annualized yields on
1 year US treasury securities are only .28%....while current annualized yields
on 2 year US treasury securities are .69% (note you may assume that both 1 and
2 year securities in this example are “0” coupon securities with no payment
other than the maturity value on the maturity date.
What does this data suggest about financial market expectations
of 1 year yields, 1 year from now? Explain…. (Assume investors are risk neutral
in these short time horizons with default free treasuries.)
6. Here’s a quote from Fed head
Janet Yellen on at a meeting in Cleveland on July 10 this year. (see
www.federalreserve.gov then click news and events…
Regarding inflation, as I mentioned earlier, the recent effects
of lower prices for crude oil and for imports on overall inflation are expected
to wane during this year. Combined with further tightening in labor and product
markets, I expect inflation will move toward the FOMC's 2 percent objective
over the next few years. Importantly, a number of different surveys indicate
that longer-term inflation expectations have remained stable even as
recent readings on inflation have fallen. If inflation expectations had not
remained stable, I would be more concerned because consumer and business
expectations about inflation can become self-fulfilling.
Explain why the FOMC is concerned not only about actual recent
inflation rates as measured by the CPI, but also about longer term
inflation expectations remaining
“stable” In particular, what is the problem if inflation
expectations start to converge to an opinion that inflation will fall to “0” or
less?
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