Econ160 Baim Winter2004

Econ160 Baim Winter2004 - Economics 160 Winter 2004 Money...

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Unformatted text preview: Economics 160 Winter 2004 Money and Banking Dean Baim, Instructor Midterm Examination Instructions 1. This examination consists of 4 sections and is worth 100 points. The distribution of points is as follows: §1 ..15 questions @ 2 points ......................... .. 3o §2 ..10 questions @ 4 points ........................ ..4o §3 ..2 question @ 10 points ......................... .. 20 §4~ TOTAL ......................................... ..100 2. You will be allowed until 4:45 to complete the exam. 3. If additional space is necessary use the back of the page and label your answer. 4. Show all your work on problems!! Incorrect answers supported by clear and substantiallfi' correct work will receive partial credit. Correct answers unsupported by work wi receive surprisingly little credit. 5. Only answers placed on the scantron sheet will be graded. 6. GOOD LUCK!! Page 2 of 5 §I—True/False-- (2 points each) Indicate whether the statement is true or false on your scantron sheet. I. 2.. 090$ II. 12. I3. 14. 15. Currency makes up more than 3/4 of the money supply. Even in an economy with money and financial assets that earn interest it may make sense for people to make at least some of their transactions using barter. Comparing the size of M2 in 1970 and 2004 will tell us how much the size of M2 MI and savings account balances has changed over the last 34 years. Since credit cards are generally accepted when buying goods and services , when Dr. Dean, the one teaching your class not the one running for president, pays for his annual spring break trip to Tahiti by using his credit card the money supply increases. Bonds typically are considered to be less risky than equities. . MOO/'8 . . . It 18 mt always has costly to use an 1ntermed1ary such as a bank or an insurance company, em those intermediaries Charge fees and make a profit. Checkable deposits areeincluded in MI but not M2. International cooperation in bank regulation has increased in the last twenty years. When interest rates increase, the return on a bond you own increases. Durin parts of 2003 some Japanese nominal rates were negative. During these perio s, the Japanese real rates were negative also. If the commission to trade stock decreased it would have no effect on the demand for US Treasury bills since US Treasury bills are already more liquid than stocks. If the price and income effect exactly offset the liquidity effect a change in the money supply will have no effect on market interest rates. When a bank increases the liquidity of its assets, it usually decreases the income it receives on its assets. Bank managers that believe that interest rates will increase in the next year will want to acquire fixed rate assets and sell variable rate liabilities if it wants to increase the size of its bank capital. The return on Wrigley International has a higher standard deviation than the returns on Sadie Corporation. This means that if the liquidity of the two firms’ shares are equal those who buy shares in Wrigley International require a higher expected return than the shareholders in Sadie Corporation. §2-Multiple choice-Select the single best answer from the alternatives given and mark the appropriate bubble on your scantron sheet (four points each). 51. Money economies are considered to be more efficient than barter economies because: a. b c d e money reduces the costs of finding a double coincidence of wants. money permits efficiency by allowing for specialization. money is the most effective way of carrying wealth into the future. All of the above are correct. “a” and “b” above are correct. Page 3 of 5 52. Financial markets and institutions increase social welfare by: a. improving decision making by creating a unit of account. b. Transferring purchasing power from those who value it less to those who value it more. c Reducing the costs of finding a double coincidence of wants. d. All of the above are correct. e. Institutions such as banks don’t increase social welfare, since these are profit maximizing institutions and their fees serve to reduce social welfare. 53. John wants to be president. His wife sells $150,000 in Heinz stock and contributes the 54- 55- 57- proceeds go John’s campaign. John’s campaign deposits the funds in a checking account. As a result: a. M1, M2, and M3 increases. b. M1 increases, but M2 and M3 decreases. c. M1 and M2 increases, but M3 decreases. d. None of the above are correct. You buy a bond on 17 February 2002 that matures in 2005. You sell the bond today. Over the last two years interest rates have declined. From this we know your return on this bond is a. higher than if interest rates had remained constant. b. lower than if interest rates remained constant. c. Unchanged since the payoff of the bond is fixed when the bond is issued. d. There is not enough information to tell. The demand for bonds will decrease, everything else held constant if: a. the current interest rate decreases. b. stock prices are expected to increase in the future. c. A new law mandates that government insured savings accounts must pay a minimum of 3% over the inflation rate (a higher rate than offered today). All of the above are correct. “b” and “c” are correct. d. e. . If an asset has a return of 18%, a b = 1.5, and the risk—free rate is 6%, the expected return on the market is: a. 6%. b. 12%. c. 14%. d. 21%. e. None of the above are correct. If Congress passes a bill that eliminates the tax on capital gains tax on bonds. This will cause interest rates to: increase decrease remain the same. There is not enough information to tell. 9-5” 7.” Page 4 of 5 58. If the liquidity effect is stronger than the price and income effect, interest rates will when the money supply increases. The word that correctly completes the sentence is: a. increase. b. decrease. c. remain the same. 59. The Baim Bank and the Bank of Thompson both have assets equal to $500 million. The Baim Bank has $25 million in bank capital while the Bank of Thompson has bank capital equal to $10 million. Which bank prudently can hold less liquid assets? a. Baim Bank b. Bank of Thompson c. It makes no difference. What is important is the liquidity of the liabilities. 60. You own shares in AMR, the parent company of American Airlines. You are interested in reducing the level of unique risk that AMR brings to your portfolio. The stock you are least likely to buy to achieve this reduction in unique risk is: a. Standard Oil. b. IBM. c. Microsoft. d. United Airlines. §3 -Mandatory Essays. Questions in this section must be answered. ANS‘VER THIS QUESTION IN THE MIDDLE SECTION OF THE SCANTRON SHEET. 3.1 The current economic forecasts are for a growing economy. Evidence of this is a growing GDP, and impressive gains in the stock market. In addition, the federal government is running a deficit of historical levels. Using the bond market model developed in class, including any applicable graphs, describe how this will affect the following: 3.1a the demand for bonds. (five points) 3.1b the supply of corporate bonds. (five points) 3.1c the market clearing price and interest rate for US Treasury securities. (five points) 3.1d the gap between the interest rates for US Treasury securities and corporate securities. (five points) Page 5 of 5 §4 —Choice Essay Questions Select one of the following essay questions, and answer it in the space provided below. Only answer one question. If you answer more than one, only the first essay be graded. Clearly mark which essay you have selected to answer. (ten points PLACE THEANSW/ER TO THIS QUESTION ON THE BACK OF YOUR SCANTRON SHEET. 4.1 4.2 Historically, the US banking system has had many more banks than its peers (such a Britain, Germany, Canada, France andJapan). For example, at last count, the US had more than 8,000 banks nationwide, while Canada had no more than 100. Despite this through the 19905 the US banking system was less competitive than the banking s stems in the other countries. Explain how the US regulatory environment made the banking industry less competitive in the US. Give specific restrictions that reduced competition among US banks. Following their meeting of 28 January 2004, the Federal Reserve Open Market Committee released a statement announcing that it would keep interest rates at their historically low levels. However, the announcement surprised many stock and bond owners by its wording that indicated that the Fed might raise interest rates sooner than expected. The announcement made stock indexes fell significantly. For example, the DowJones Industrial Average fell about 1.5% in the next two hours. Explain why the Fed’s announcement that it might raise interest rates later this year would cause asset prices to fall. I. 7. 9. II 12 13 I4 5 I 3.1 a) The increasing expected returns on the stock market Will cause the eXpected return on bonds to be relatively lower. Therefore, the demand for bonds will be less than before. This is shown graphically below. Price b) The improving econom increases the profitability of future , investments. This makes films more willing to want to borrow so they can take advantage of the higher future demand for their products. This is represented by an increase in the supply of corporate bonds. 31 Price r Q/t c) The demand for US Treasuries has declined (from part a). In addition, the growing US government deficit will cause the supply curve of US T to increase. The combined effects of these two changes causes the price of USTs to decrease, and the interest rates on USTs paid to buyers of the bonds will increase. In the gra h below, demand changes from DI to D2, while supply increases fi‘orn SI to 82. The new market clearing price moves from PI to P2, which draws the interest rate up from rI to r2. Price (1) Corporate bonds will have a higher interest rates than US Treasuries because of the reduced liquidi and hi her risk characteristics that corporate bonds have that US s don’t ave. In this case, however, the increased expected profitability of future private ventures (described in part b) will cause the spread between USTs and corporate bonds to increase more, since the increased supply of corporate bonds will cause ii a g; W {.3 ‘4‘ page» .4» i the price of corporate bonds to decrease and the interest rate received from buyers of the corporate bonds at the new price to increase. 4.1 The US banking system was not competitive during through the 19908 because of regulations that historically restricte competition. Among the restrictions that were imposed were restrictions on the types of assets that banks could hold. Thus some institutions could not make consumer loans or issue credit cards. Others could not make small business loans. By reducing the number of institutions that could compete for a given product, the regulations served to reduce the com etition for these products. Another kind of anti—competitive reguliition was the regulation regarding interstate banking. This restricted entry of banks chartered out of state. Besides reducing competition to just in—state rivals, the banks also were not allowed to take advantage of any economies of scale that might have been available b expanding the bank’s size beyond state boundaries. he result of these regulations is that they caused the number of banks in the US to be higher than otherwise would be expected (the restrictions on interstate banking made it necess for there to be duplicate sets of banks than efficient—and the arti 1cially high profitability would attract entry, whenever allowed, into the industry). Yet despite this hi her number of banks, there was less competition than if there were gewer banks. ' NB: The restriction on interest rates paid to depositors also limited competition for depositors, but that was'rem0ved in the 29803. While it is tangentially relevant to the question, it is not directly related to the question which explicitly deals with the 19905. Instructions to the ader: If the student mentions the deposit rate restrictions do not deduct [points or this portion of the answer, but do not add points because this was inc uded. 4.2 The rice of any financial asset (including stocks) is the present value of t e asset’s expected cash flows. Present value is computed from the formula: 01+ (22 + c3 c, (1+7) (1+r)2 (1+r)3 (1+r)7 Where c, is the cash expected to be received in period, and r is the interest rate. PV= If the Fed indicates that interest rates will increase in the future, this means the later periods will have higher rates than was expected. These changes are then raised to powers appropriate for that period which causes rather modest changes in interest rates to have significant increases in prices. M M M A not so good an answer would be that the if the Fed increases interest rates, the impact is expected to be a decrease in future economic activity, which will reduce the profitability of most firms. This is reflected in smaller future cash payments than originally expected, which would reduce the price of stock. Again, this answer should get fewer points than the first answer. ...
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This note was uploaded on 05/13/2008 for the course ECON 160 taught by Professor Baim during the Winter '98 term at UCLA.

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Econ160 Baim Winter2004 - Economics 160 Winter 2004 Money...

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