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Economics 310 Money and Banking Practice Midterm Exam Winter 2008

The actual midterm will involve only 25 multiple choice questions, to be completed in 80 minutes. No calculators, no cell phones, no personal digital media players or any other electronic equipment should be visible or in use during the exam. Each question will score 4 points if correct, 1 point if unanswered and 0 points if incorrect. This means that your final exam score will lie between 0 and 100, but that you can score 25 points simply by turning in a blank exam. It also means that a complete guess will score 4 points with probability ¼ and 0 points with probability ¾. On average, such a guess will score 1 point, which is exactly what you would get if you didn’t bother answering in the first place.

2 of 9 1. Which of the following is not commonly identified as a role of money? (a) (b) (c) (d) Money is a store of value Money is a unit of account Money avoids the need for a double coincidence of wants. Money counters the effects of Gresham’s Law.

2. Suppose the Fed looks to make an open market sale to the banking sector of $1 million worth of securities. If you were to trace the effects of this through the T-accounts for the Fed, the banking sector as a whole and the general public, which of the following would you observe? (a) (b) (c) (d) Bank reserves held at the Fed would increase by $1m. Bank reserves held at the Fed would decrease by more than $1m. Money supply would fall by more than $1m. Bank deposits would increase by more than $1m.

3. Amy is considering buying a nominally denominated coupon bond at the prevailing price, P. Which of the following will increase expected real returns on the bond over the next year, if other things are held constant? (a) (b) (c) (d) Higher inflation expectations for the year. Higher expectations for future interest rates. Lower expectations for future interest rates. A lower current inflation rate.

4. Suppose inflationary expectations fall. By considering the bond market, which of the following predictions would you make? (a) (b) (c) (d) Bond prices fall and there is an ambiguous effect on quantity of bonds traded. Interest rates fall and the quantity of bonds traded falls. Bond prices rise and the quantity of bonds traded rises. Interest rates fall and there is an ambiguous effect on quantity of bonds traded.

3 of 9 5. Consider the following statements concerning the money base. (i) (ii) (iii) (iv) Base money is equal to the currency in circulation plus bank reserves Base money represents the liabilities of the central bank Base money is that portion of the money supply that is directly controllable by the central bank The Fed focuses on controlling the interest rate because changing Base Money through open market operations has very little impact on M1.

Which of the above statements are true? (a) (b) (c) (d) (i) and (ii) (i) (ii) and (iii) (i), (iii) and (iv) (i), (ii), (iii) and (iv)

6. In the simple deposit multiplier model (a) (b) (c) (d) banks hold an arbitrary amount of money as excess reserves any funds borrowed by the general public are held as currency any funds borrowed by the public are held as checking deposits the required reserve ratio is equal to 10%.

7. Consider the following two bonds at the time they are issued: I : a five year coupon bond with face value $1000 and coupon rate 5% II: a one year discount bond with face value $1000. Which of the following statements is true? (a) If the price of bond I is $1010, then the yield to maturity on bond I is greater than 5% (b) If the price of bond II is $800, then the yield to maturity is 20%. (c) The higher the yield to maturity offered on bond II, the higher its current price will be. (d) If the price of bond I is $975 and the price of bond II is $900, then the yield to maturity on both bonds is greater than 5%.

4 of 9 8. In the money multiplier model . (a) if everything else is held constant, the money supply will be larger if the banks hold a larger proportion of deposits as excess reserves. (b) if everything else is held constant, the money supply will be larger when the public holds a smaller proportion of borrowed funds as currency. (c) any funds borrowed by the general public must be held in checking deposits. (d) the amount of reserves banks hold in excess of their requirements depends only on the interest rate. 9. On April 1 2005, the Department of the Treasury issued a 5 year Treasury Inflation Protected Security and a 5 year Treasury note. Both had face values of $1000. The 5 year TIPS offered a coupon rate of 2.5% and the Treasury note offered a coupon rate of 5%. When the bonds were released, the price of the 5 year TIP security was $1000 and the price of the 5 year Treasury note immediately jumped down to $950. From this we can conclude: (a) that inflation was expected to run above 2.5% on average over the next five years. (b) that inflation was expected to run below 2.5% on average over the next five years. (c) that the price of the Treasury note was expected to increase more slowly than the price of the TIP security. (d) that expected real return on the 5 year Treasury note is higher than the expected real return on the 5 year TIP security. 10. Gresham’s Law states that (a) Bad money drives out the good (b) Inflation is primarily a monetary phenomenon (c) The nominal interest rate exceeds the real interest rate by the expected inflation rate (d) Bond prices and interest rates are inversely related 11. In the text, Mishkin observes that interest rates on bonds tend to fall during recession. This is most easily explained by (a) Simultaneous rightward shifts in the demand and supply curves for bonds; the shift in demand is large relative to the shift in supply so that equilibrium bond prices rise. (b) Simultaneous leftward shifts in the supply and demand curves for bonds; the shift in supply is large relative to the shift in demand so that equilibrium bond prices rise. (c) A rightward shift in the demand curve for bonds and a leftward shift in the supply curve for bonds. (d) Expansionary fiscal policy from the Federal government during recession: increased deficits imply increased borrowing on the bond market.

5 of 9 12. Which of the following is true? (a) During the expansionary phase of the business cycle, the difference between yields on Treasury bonds and Baa rated bonds is likely to increase. (b) Corporate bond prices are much more sensitive to changes in income tax rates than municipal bond prices. (c) Municipal bonds tend to offer lower yields than Treasury bonds because they present a higher default risk. (d) Junk bonds are high risk bonds. The large junk bond risk premium results in a much higher price for junk bonds, and so a lower yield. 13. The yield curve is almost always observed to slope upwards. Which of the following presents the most plausible explanation of this phenomenon? (a) People almost always anticipate that short term interest rates will be higher in the future. (b) This is simply a reflection of compounding of interest. If an agent holds an asset for twice as long, that agent should expect twice the return. (c) Long-term bonds must be held until maturity. Bond holders, therefore, will require a premium to compensate for this extreme lack of liquidity. (d) Interest rate risk on long term bonds is higher than on short term bonds, so a premium must be offered to compensate for this risk. 14. Financial commentators often interpret an inverted yield curve as a sign of impending recession because: (a) it implies that short term interest rates are likely to rise, and this will reduce investment; (b) it implies that short term interest rates are likely to fall, and this will reduce investment; (c) it implies that the central bank is liable to raise interest rates, and slow down the economy; (d) it implies that the central bank will be forced to reduce interest rates significantly in order to stimulate economic activity. 15. Which of the following statements is NOT true of the cigarette currency described in Radford’s article, “The Economic Organization of a POW Camp”? (a) (b) (c) (d) Cigarettes were a form of fiat money. Cigarettes were used as a unit of account. Cigarettes were used as a store of value. Cigarettes were used as a medium of exchange.

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16. Which of the following actions will lead directly to a reduction in the money base? (a) The First National Bank transfers funds from its reserve account to the Second National Bank’s reserve account to settle a customer’s checking account transaction. (b) A customer of the First National Bank deposits $100 in cash into her checking account. (c) The central bank sells $1m of gold from its vaults. (d) The central bank buys $1m in Treasury bonds. 17. If the central bank buys $1000-worth of bonds on the open market then: (a) the money base will rise by $1000. M1 will increase as well, and that increase will be larger if the central bank imposes higher reserve requirements on the banks; (b) the money base will rise by $1000. M1 will increase as well, and that increase will be smaller if the central bank imposes higher reserve requirements on the banks; (c) the money base will fall by $1000. M1 will fall as well, and that decrease will be larger if the central bank imposes higher reserve requirements on the banks; (d) the money base will fall by $1000. M1 will fall as well, and that decrease will be smaller if the central bank imposes higher reserve requirements on the banks; 18. If iT is the yield-to-maturity on a 10-year Treasury bond, and iC is the yield-tomaturity on a 10-year Baa-rated corporate bond, then we would expect a recession to cause (a) (b) (c) (d) a decrease in (iC – iT); an increase in (iC – iT); no change in (iC – iT); iC to remain above iT, but the effect on (iC – iT) to be ambiguous

19. Let the currency ratio be 0.6, the excess reserve ratio be 0.1 and the required reserve ratio be 0.1. If the central bank sells $5m of securities in the open market, then the money multiplier model predicts that the M1 money supply will (a) (b) (c) (d) contract by $5m; contract by $10m; expand by $50m; expand by $10m.

7 of 9 20. A discount bond has face value of $450 and matures in two years’ time. If the yieldto-maturity on this bond is 50%, and that interest rate remains constant over the full two years until it matures, then (a) (b) (c) (d) the initial price of the bond is $200, and the price after 1 year is $325; the initial price of the bond is $150, and the price after 1 year is $300; the initial price of the bond is $200, and the price after 1 year is $300; the initial price of the bond is $300, and the price after 1 year is $450.

21. Bethany wishes to store her wealth by purchasing the bond with the highest yield-tomaturity. She is indifferent between the following two bonds that are being issued today: I. A Treasury Inflation Protected Security (TIPS) that matures in five years time, has face value of $500 and a coupon rate of 10% ; II. A nominal coupon bond issued by the Treasury, with face value of $1000 and a maturity date exactly five years from today that pays a coupon payment of $250 each year. If the price of the first bond is $500, and inflation is expected to remain around 10% over the next five years, then the price of the second bond should be: (a) (b) (c) (d) greater than $1000; $1000; between $1000 and $500; $500.

22. Mishkin presents evidence to suggest that interest rates move pro-cyclically. If, for example, the interest rate on 30-day Treasury Bills is pro-cyclical, then the expectations model of the term structure of interest rates would suggest that: (a) the yield curve typically will be upward sloping; (b) the yield curve typically will be downward sloping; (c) the yield curve will be upward sloping when the economy is anticipating a recession; (d) the yield curve will be downward sloping when the economy is anticipating a recession.

8 of 9 23. Consider two coupon bonds. Both have face value of $1000, and both sell for $1000 today. The first bond matures in two years and the second bond matures in ten years. Both bonds have a yield-to-maturity of 10% per year. Suppose that, over the course of the next year, the yield-to-maturity on both bonds falls from 10% to 5%. Then (a) the one-year return on both bonds is lower than 10%, but the return on the 2 year bond will be lower than the return on the 10-year bond; (b) the one-year return on both bonds is lower than 10%, but the return on the 10 year bond will be lower than the return on the 2-year bond; (c) the one-year return on both bonds is higher than 10%, but the return on the 2year bond will be higher than the return on the 10-year bond; (d) the one-year return on both bonds is higher than 10%, but the return on the 10year bond will be higher than the return on the 2-year bond. 24. Imagine that inflation has been steady for the past few years at around 5% per year. But economy-wide predictions suggest inflation rates will rise. What sort of effect will this have in the bond market? (a) (b) (c) (d) Bond prices fall and there is an ambiguous effect on quantity of bonds traded. Interest rates rise and the quantity of bonds traded rises. Interest rates fall and the quantity of bonds traded falls. Interest rates fall and there is an ambiguous effect on quantity of bonds traded.

25. Which of the following is most likely to increase the interest rates earned on bonds? (a) Brokerage fees associated with trading bonds fall, leading to increased liquidity in the bond market. (b) The Federal government announces a larger-than-expected budget deficit. (c) Improvements in accounting regulations and financial reporting practices reduce the default risk on newly issued corporate bonds. (d) Increases in corporate taxes that reduce profitability of private sector investment opportunities.

9 of 9 Answer Key 1. D 2. C 3. C 4. D 5. B 6. C 7. D 8. B 9. A 10. A 11. B 12. B 13. D 14. D 15. A 16. C 17. B 18. B 19. B 20. C 21. A 22. D 23. D 24. A 25. B