ECON 160 Spring 2009 Midterm

ECON 160 Spring 2009 Midterm - Economics
160
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Unformatted text preview: Economics
160
 Money
and
Banking
 
 
 
 Spring
2009
 Dean
Baim,
Instructor
 Midterm
Examination
 Instructions
 1.
Place
your
name
on
the
answer
sheet.
 2.
This
examination
consists
of
4
sections
and
is
worth
100
points.

The
distribution
of
points
 is
as
follows:
 
 Section
Number
 Questions
 Points
 
 §1 ........ [email protected] .................. 22
 
 
 §2 ........ Multiple
Choice
 
 [email protected] .................................... 48
 
 
 §3 ........ Mandatory
Essay
1
question
 ................ 20
 
 
 §4 ........ Choice
Essay
1
question ........................ 10
 
 TOTAL ...........................................100
 
 3.
You
will
be
allowed
until
10:45
to
complete
the
exam.
 
 4.
Show
all
your
work
on
problems!!
Incorrect
answers
supported
by
clear
and
substantially
 correct
work
will
receive
partial
credit.

Correct
answers
unsupported
by
work
will
receive
 surprisingly
little
credit.
 
 5.
 Place
all
your
answers
on
the
answer
sheet.

Only
responses
on
the
answer
sheet
will
be
 graded.
 
 6.
GOOD
LUCK!!
 Page
2
of
9
 
 Start
you
answers
on
the
portion
of
the
answer
sheet
that
 starts
with
answer
1
 Indicate
if
the
following
statements
are
true,
false
by
circling
either
T
or
F
on
your
answer
 sheet.

Answer
these
questions
on
the
answer
sheet
questions
that
start
with
the
number
1.
 1.
 
 
 §1–True/False
 Money
and
financial
assets
are
reasonable
stores
of
wealth
during
periods
of
high
 inflation.

 Between
1995
and
2004
those
countries
with
higher
levels
of
money
supply
growth
had
 higher
inflation
rates.

 Financial
markets
can
help
those
who
do
not
engage
in
savings
or
borrowing.
 Given
its
conservative
nature,
the
Regan
administration
did
not
use
regulation
to
 promote
social
goals.

 If
you
pay
cash
for
a
house
you
do
not
incur
an
interest
cost.
 For
fixed
rate
assets,
such
as
most
bonds,
the
return
on
the
asset
will
be
higher
if
the
 market
interest
rate
increases
after
you
purchase
the
bond
and
before
you
sell
it
than
if
 the
market
rate
remained
constant.
 
Asset
A
has
a
higher
β
than
asset
B.

Asset
A
will
have
a
higher
expected
return
than
 Asset
B
even
though
Asset
A
has
a
smaller
standard
deviation.


 When
the
liquidity
effect
is
greater
than
the
price
and
income
effects,
interest
rates
will
 decline
if
the
money
supply
increases.
 Bank
A
and
Bank
B
have
the
same
value
of
total
assets.

Bank
A,
however,
has
more
 bank
capital
than
Bank
B.
Bank
A
can
earn
a
higher
income
from
its
assets
than
Bank
B
 and
not
increase
Bank
A’s
level
of
exposure
to
failure.
 2.
 
 3.
 
 4.
 
 5.
 
 6.
 
 7.
 
 8.
 
 9.
 
 10.
 You
have
a
$3,000
balance
on
your
credit
card
issued
by
Wrigley
Bank.

If
you
declare
 bankruptcy
and
get
the
$3,000
balance
discharged,
Wrigley
Bank
will
decrease
its
total
 assets
by
$3,000
and
its
total
liabilities
by
$3,000.
 
 11.
 In
the
past
nine
months,
the
stock
market
has
been
considered
to
be
more
risky
than
 before.

Despite
the
increase
in
the
risk
of
the
stock
market,
there
was
no
effect
on
the
 demand
for
US
Treasury
securities
since
they
are
already
considered
to
be
risk‐free.
 
 Page
3
of
9
 
 Start
you
answers
on
the
portion
of
the
answer
sheet
that
starts
with
answer
51
 Indicate
which
of
the
alternatives
represents
the
single
best
answer
on
your
answer
 sheet.
(four
points
each).
 
 §2–Multiple
Choice
 51.
 If
an
asset
is
generally
accepted
for
the
final
payment
of
goods
and
services
and
the
 settlement
of
debt
it:

 a.
 increases
efficiency
because
it
serves
as
a
medium
of
exchange.
 b.
 will
be
a
way
to
store
wealth
from
one
period
to
another.

 c.
 helps
decision
making
and
record
keeping
by
being
a
unit
of
account.
 d.
 is
money.
 e.
 All
of
the
above
are
true.
 
 52.
 When
classifying
financial
markets
a
money
market
is
one
where:
 a.
 the
asset
will
mature
in
one
year
or
less
from
the
time
of
issue.
 b.
 unlike
non‐money
markets
where
a
buyer
can
pay
for
the
asset
using
credit,
a
 buyer
has
to
pay
cash
for
the
assets.


 c.
 the
asset
being
bought
or
sold
is
currency.
 d.
 None
of
the
above
is
true.
 
 53.
 According
to
Bloomberg.com
on
May
8,
2009
a
two‐year
Treasury
bonds
was
earning
an
 annual
rate
of
0.92%.

On
November
8,
2009
a
two‐year
Treasury
security
was
earning
an
 annual
rate
of
2.55%.

From
these
returns
we
can
conclude:
 a.
 the
price
of
two‐year
treasury
bonds
decreased
between
November
2008
and
 May
2009.
 b.
 the
price
of
two‐year
treasury
bonds
increased
between
November
2008
and
 May
2009.
 c.
 prices
for
two‐year
treasury
bonds
remained
the
same,
they
just
became
more
 risky,
so
the
interest
rate
on
them
fell.
 d.
 prices
may
or
may
not
have
changed.

There
is
not
enough
information
to
tell.
 
 54.
 The
major
function
of
financial
intermediation
in
a
market
economy
is
to:
 a.
 enrich
lenders
by
increasing
their
returns
net
of
search
costs.
 b.
 enrich
borrowers
by
reducing
their
costs
of
funds.
 c.
 enrich
banks
by
increasing
their
profits.
 d.
 move
financial
resources
to
their
most
highly
valued
uses.
 e.
 extend
the
power
of
the
regulatory
authorities.
 
 
 
 
 
 
 
 Page
4
of
9
 
 55.
 Which
of
the
following
event(s)
will
cause
interest
rates
to
increase?
 a.
 Wealth
increases.
 b.
 The
US
government
runs
a
smaller
deficit.
 c.
 Bond
issuers
decrease
their
expectations
regarding
inflation
next
year.
 d.
 Bond
buyers
increase
their
expectations
regarding
next
year’s
inflation.
 e.
 a,
b,
and
c
are
correct.
 
 56.
 Bruin
Bank
is
considering
two
loans
and
can
finance
only
one.

Loan
#1
is
a
business
loan
 to
a
residential
real
estate
developer.

The
owner
if
the
business
has
maintained
a
 modest
relationship
with
the
bank
for
the
last
fifteen
years–the
developer
has
 maintained
small
deposits,
but
Bruin
Bank
is
under
the
distinct
impression
that
it
is
not
 the
developer’s
main
bank.

The
development
is
located
in
the
region
Bruin
Bank
does
 business
and
is
where
most
of
Bruin
Bank’s
current
loans
are
made.


 Loan
#2
is
an
application
from
a
car
dealer
who
needs
a
short‐term
loan
to
order
more
 cars
for
her
inventory.
The
dealer
has
not
had
any
relationship
with
Bruin
Bank
prior
to
 loan
application.

 Both
the
applicants
for
loan
#1
and
loan
#2
have
the
same
risk
profiles
(β,
σ,
and
the
 income
to
loan
ratios
are
the
same
for
both
loan
#1
and
loan
#2).

Both
loans
have
the
 same
expected
return.

 Bruin
Bank
is
a
small
neighborhood
bank
that
has
focused
on
its
neighborhood
 relationships.

Its
interest
bearing
assets
are
made
up
mostly
of
business
loans
to
local
 real
estate
developers
and
residential
mortgages.
 If
Bruin
Bank
wanted
to
mitigate
default
risk
it
should:
 a.
 Make
the
loan
to
the
local
real
estate
developer.

By
rewarding
his
loyalty
to
 Bruin
Bank
he
is
more
likely
to
increase
his
business
activity
at
Bruin
Bank.
 b.
 Make
the
loan
to
the
out‐of‐town
car
dealer.

The
car
dealer’s
loan
will
diversify
 the
type
of
loans
as
well
as
increase
geographic
diversity
so
Bruin
Bank
will
not
 be
as
vulnerable
to
a
downturn
in
the
local
real
estate
market.
 c.
 It
does
not
make
a
difference
to
Bruin
Bank
which
loan
it
should
accept.

Since
β,
 the
standard
deviation
of
the
applicants’
incomes
and
the
ratio
of
loan
to
 income
are
the
same,
Bruin
Bank’s
risk
exposure
is
the
same
regardless
of
the
 loan
it
makes.
 d.
 There
is
not
enough
information
to
answer
this
question.
 
 Page
5
of
9
 
 57.
 Due
to
the
series
of
bank
failures
and
financial
market
turmoil,
individuals
have
been
 withdrawing
money
from
their
savings
accounts
and
keeping
the
withdrawals
as
cash.

 What
has
been
the
impact
of
these
transactions
on
M1
and
M2?
 a.
 M1
will
increase,
M2will
decrease
by
the
same
amount
M1
increases.
 b.
 M1
will
increase,
M2
will
increase
by
the
same
amount
M1
increases.
 c.
 M1
will
increase,
M2
will
remain
the
same.
 d.
 M1
will
decrease,
M2
will
decrease.
 
 58.
 The
US
Treasury
recently
concluded
its
publicized
stress
tests
by
mandating
that
the
 banks
have
to
raise
a
total
of
$75
billion
in
new
bank
capital.

The
Financial
Times
 reported
the
government
has
assured
the
banks
that
are
required
to
raise
more
capital
 will
have
to
raise
less
than
the
amount
mandated
by
the
stress
tests
“if
earnings
over
 the
next
six
months
outstrip
regulators’
forecasts.”
 
 If
banks
wish
to
reduce
the
capital
they
must
raise
in
the
next
six
months
by
having
 unexpected
good
earnings
which
of
the
following
policies
would
they
institute
to
 improve
their
earnings?
 a.
 delay
writing
off
losses
from
non‐performing
loans
and
let
the
allowance
for
 loan
losses
to
increase.
 b.
 raise
interest
rates
paid
to
depositors,
thus
attracting
more
money
that
can
be
 used
to
acquire
risky

loans
and
securities
that
pay
a
higher
interest.
 c.
 Sell
off
the
bank’s
corporate
bond
holdings
and
hold
the
cash
as
reserves
since
 the
Fed
is
now
paying
interest
on
reserves.
 d.
 None
of
the
above
would
increase
reported
earnings.
 
 59.
 A stock with a high variance to its returns must: 
 a.
 have
a
higher
relevant
risk.
 b.
 pay
a
higher
expected
return
than
an
asset
with
a
low
variance
returns.
 c.
 have
a
higher
standard
deviation
than
an
asset
with
low
variance
returns.
 d.
 none
of
the
above
are
correct.
 
 60.
 Bank
B
has
the
same
level
of
total
assets
and
total
liabilities
as
Bank
A,
but
Bank
A
has
 almost
all
of
its
assets
in
reserves
while
Bank
B
has
fewer
reserves.

Bank
A
will
be
able
 to:
 a.
 make
a
higher
income
than
Bank
B.
 b
 withstand
larger
withdrawals
than
Bank
B
without
having
to
disturb
its
income
 generating
assets.
 c.
 more
easily
borrow
the
reserves
it
will
need
to
meet
the
minimum
reserve
 requirement.
 d.
 have
a
higher
bank
capital
than
Bank
B.
 
 
 
 
 
 Page
6
of
9
 
 61.
 If
prices
rise
at
a
faster
than
expected
rate:
 a.
 real
interest
rates
will
be
higher
than
expected.
 b.
 nominal
interest
rates
will
fall.
 c.
 debtors
will
be
repaying
loans
with
dollars
that
are
worth
less
than
expected.
 d.
 it
will
have
no
economic
impact,
because
it
was
unexpected.
 62.
 The
price
of
a
one‐year
subscription
to
Popular
Money
and
Banking
is
$25
and
a
two‐year
 subscription
costs
$45.

Assuming
that
prices
are
expected
to
remain
constant
and
that
 there
are
no
transaction
costs,
the
implied
interest
rate
of
interest
is:
 a.

 10%.
 b.
 25%.
 c.
 50%.
 d.
 80%.
 Page
7
of
9
 
 §3‐Mandatory
Essay/Problems
 All
the
questions
in
this
section
are
required
 3.1
START
YOUR
ANSWER
TO
THIS
QUESTION
ON
THE
FRONT
OF
YOUR
ANSWER
SHEET
(PAGE
1)
 AND
CONTINUE
IT
ON
TO
PAGE
4
(THE
BACK
OF
THE
ANSWER
SHEET).
 You
get
to
be
a
regulator!!!

You
have
the
responsibility
of
measuring
the
impact
of
defaults.

 You
know
the
following
information
about
American
Bank
(all
numbers
are
in
millions):
 AB
has:
 • $250
in
demand
deposits
 • $30
in
reserves
 • $400
in
mortgages
 • $250
in
certificate
of
deposits.
 • $150
in
car
loans
 • $150
in
US
Treasury
notes
 • $150
in
municipal
bonds
 • $150
in
corporate
bonds
 • $200
in
savings
account
balances
 • $100
in
borrowings
($50
is
funds
given
to
AB
last
fall
as
rescue
funds
and
are
 preferred
stock
which
are
recorded
as
borrowings).
 • $20
in
other
reserves
 AB
operates
in
the
following
regulatory
environment
 • a
regulation
of
10%
of
demand
deposits
be
held
as
required
reserves
 • a
regulation
that
AB
must
maintain
20%
of
its
total
assets
as
bank
capital.
 3.1
a


Use
the
information
above
to
complete
following
balance
sheet
template
for
AB.
On
 your
answer
sheet
list
these
line
items
and
the
correct
amounts
next
to
them.
(five
 points)
 Assets
 Required
Reserves
 Excess
Reserves
 Securities
 Loans
 Other
Assets
 Total
Assets
 $
 $
 $
 $
 $
 $
 Liabilities
 Demand
Deposits
 $
 Time
Deposits
 $
 Borrowings
 $
 Total
Liabilities
 $
 
 Bank
Capital
 $
 3.1b
 From
the
balance
sheet
you
have
completed
to
answer
question
3.1a,
does
AB
have
 sufficient
capital?

Explain
why
or
why
not?

(four
points)
 Question
3.1
continues
on
the
next
page
 
 Page
8
of
9
 
 3.1c
 As
part
of
the
stress
test
you
estimate
that
if
the
economy
were
to
worsen
5%
of
the
 mortgages
would
default.

You
also
estimate
that
10%
of
AB’s
car
loansand
10%
of
AB’s
 corporate
bonds
will
default.

Assume
that
a
default
loan
will
be
worth
zero
and
must
 be
subtracted
in
full
from
that
category
of
asset.

Use
this
information
to
complete
the
 following
balance
sheet
template
for
AB
on
your
answer
sheet.

(five
points)
 Assets
 Required
Reserves
 Excess
Reserves
 Securities
 Loans
 Other
Assets
 Total
Assets
 $
 $
 $
 $
 $
 $
 Liabilities
 Demand
Deposits
 $
 Time
Deposits
 $
 Borrowings
 $
 Total
Liabilities
 $
 
 Bank
Capital
 $
 3.1d
 Use
your
answer
to
part
3.1c
to
compute
how
much
additional
capital
AB
must
raise
 after
the
defaults
to
satisfy
the
minimum
capital
requirements.

Support
your
answer
 with
an
explanation
and
computations.

(five
points)
 
 §4
Choice
Essay/Problems
 Answer
either
all
of
either
4.1
or
4.2.

If
you
answer
both,
only
your
answer
to
4.1
 will
be
graded.

Place
your
answer
in
the
inside
of
the
answer
sheet.
 4.1
 Yesterday
the
US
Postal
Service
raised
the
price
of
a
first‐class
stamp
from
$0.42
to
 $0.44.

However,
the
post
office
has
issued
“forever
stamps”.


Forever
stamps
are
 unique
in
that
they
are
sold
at
whatever
the
prevailing
first
class
rate
is
at
the
time
of
 sale,
but
are
accepted
for
first‐class
postage
when
they
are
used.

Thus,
if
one
 purchased
the
forever
stamp
when
the
first‐class
postage
was
$0.42
it
could
be
used
at
 the
higher
rate
of
$0.44

which
started
yesterday.
 4.1a
 When
the
postage
rate
increased
yesterday
(May
11,
2009)
what
is
the
rate
of
return
 you
earned
if
you
had
purchased
$4,200
of
forever
stamps
on
May
11,
2008?

Show
all
 your
calculations.

(five
points)
 4.1b
 According
to
the
Federal
Reserve
you
could
have
earned
a
return
of
2.06%
if
you
had
 bought
a
one‐year
US
Treasury
security
in
May
2008
and
held
it
to
maturity.

There

is
 no
risk
of
default
for
either
the
stamps
and
the
treasury
security.

Why
would
you
most
 likely
put
your
$4,200
in
the
US
Treasury
security
than
in
forever
stamps?

(five
points)

 
 4.2
 The
United
States
has
imposed
a
restriction
on
trade
and
investment
in
Cuba
since
 February
1962.


The
two
countries’
financial
systems
are
completely
separate
and
 funds
do
not
flow
between
them
to
finance
investment.

Compared
to
the
US,
Cuba
is
 underdeveloped,
with
little
investment
occurring
over
the
last
forty‐five
years
and
 limited
domestic
funds
and
small
amounts
of
accumulated
wealth.

The
US
economy
is
 mature.

Because
of
the
lack
of
investment
over
almost
a
half
century
in
Cuba,
the
US
 has
fewer
new
investment
opportunities
than
Cuba
and
but
the
US
has
larger
amounts
 of
wealth.


 Question
4.2
is
continued
on
the
next
page.
 Page
9
of
9
 
 4.2a
 Using
the
bond
market
model
developed
in
class
would
the
interest
rates
be
higher
in
 Cuba
or
the
US
if
investment
in
both
places
is
funded
mostly
through
bonds.


A
graph
 and
an
explanation
would
be
useful
in
answering
this
question.
(three
points)
 4.2b
 Use
the
model
of
the
bond
market
to
predict
what
would
happen
to
the
interest
rates
 in
both
countries
if
the
embargo
was
lifted
and
funds
could
flow
without
restriction
 between
Cuba
and
the
US?

(four
points)
 4.2c
 Would
more
profitable
investment
projects
be
financed
and
undertaken
if
the
embargo
 is
lifted?

Why
or
why
not?

(three
points)
 NB:

 I
realize
this
is
a
controversial
topic
that
has
political
overtones.

If
you
choose
to
 answer
question
4.2
please
restrict
your
answer
to
the
economics
asked
in
the
question
 and
refrain
from
interjecting
your
normative
views
of
Cuba,
Castro,
the
Cuban
 embargo,
etc.

Answers
like,
“We
had
to
do
this
because
Castro
is
bad”,
or
“We
have
 been
dumb
to
isolate…”
will
earn
surprisingly
little
credit
since
how
you
feel
about
the
 issue
is
not
relevant
to
the
question
that
is
posed.


 3.1
START
YOUR
ANSWER
TO
THIS
QUESTION
ON
THE
FRONT
OF
YOUR
ANSWER
SHEET
(PAGE
1)
AND
 CONTINUE
IT
ON
TO
PAGE
4
(THE
BACK
OF
THE
ANSWER
SHEET).
 You
get
to
be
a
regulator!!!

You
have
the
responsibility
of
measuring
the
impact
of
defaults.

 You
know
the
following
information
about
American
Bank
(all
numbers
are
in
millions):
 AB
has:
 • $250
in
demand
deposits
 • $30
in
reserves
 • $400
in
mortgages
 • $250
in
certificate
of
deposits.
 • $150
in
car
loans
 • $150
in
US
Treasury
notes
 • $150
in
municipal
bonds
 • $150
in
corporate
bonds
 • $200
in
savings
account
balances
 • $100
in
borrowings
($50
is
funds
given
to
AB
last
fall
as
rescue
funds
and
are
 preferred
stock
which
are
recorded
as
borrowings).
 • $20
in
other
reserves
 AB
operates
in
the
following
regulatory
environment
 • a
regulation
of
10%
of
demand
deposits
be
held
as
required
reserves
 • a
regulation
that
AB
must
maintain
20%
of
its
total
assets
as
bank
capital.
 3.1
a


Use
the
information
above
to
complete
following
balance
sheet
template
for
AB.
On
 your
answer
sheet
list
these
line
items
and
the
correct
amounts
next
to
them.
(five
 points)
 Assets
 Required
Reserves
 Excess
Reserves
 Securities
 Loans
 Other
Assets
 Total
Assets
 $25
 $05
 $450
 $550
 $20
 $1,050
 
 Time
Deposits
 Borrowings
 Total
Liabilities
 
 Bank
Capital
 Liabilities
 Demand
Deposits
 $250
 $450
 $100
 $800
 $250
 
 3.1b
 From
the
balance
sheet
you
have
completed
to
answer
question
3.1a,
does
AB
have
 sufficient
capital?

Explain
why
or
why
not?

(four
points)
 AB has sufficient capital. The minimum requirement is 2% of the total assets. Total assets equal $1,050, so 2% of that is $21. The bank has $250, so it has more capital than the legal requirement. 3.1c
 As
part
of
the
stress
test
you
estimate
that
if
the
economy
were
to
worsen
5%
of
the
 mortgages
would
default.

You
also
estimate
that
10%
of
AB’s
car
loans
and
10%
of
AB’s
 corporate
bonds
will
default.

Assume
that
a
default
loan
will
be
worth
zero
and
must
 be
subtracted
in
full
from
that
category
of
asset.

Use
this
information
to
complete
the
 following
balance
sheet
template
for
AB
on
your
answer
sheet.

(five
points)
 5% of the mortgages will be written off. That is $20 million. 10% of the car loans ($15 million) are written off. This means $35 million will be written down to zero. 10% corporate bonds will be written down as well. That means securities will decline by $15 million. 
 Assets
 Required
Reserves
 Excess
Reserves
 Securities
 Loans
 Other
Assets
 Total
Assets
 $25
 $05
 $435
 $515
 $2 0 
 $1,000
 Time
Deposits
 Borrowings
 Total
Liabilities
 Liabilities
 Demand
Deposits
 $250
 $650
 $100
 $800
 
 
 Bank
Capital
 $200
 3.1d
 Use
your
answer
to
part
3.1c
to
compute
how
much
additional
capital
AB
must
raise
 after
the
defaults
to
satisfy
the
minimum
capital
requirements.

Support
your
answer
 with
an
explanation
and
computations.

(five
points)
 The bank will have $200 in bank capital after the writeoffs. Given that the bank has $1,000 in total assets it should have at least $20 in bank capital. AB will not have to raise any additional capital. §4
Choice
Essay/Problems
 Answer
either
all
of
either
4.1
or
4.2.

If
you
answer
both,
only
your
answer
to
4.1
 will
be
graded.

Place
your
answer
in
the
inside
of
the
answer
sheet.
 4.1
 Yesterday
the
US
Postal
Service
raised
the
price
of
a
first‐class
stamp
from
$0.42
to
 $0.44.

However,
the
post
office
has
issued
“forever
stamps”.


Forever
stamps
are
 unique
in
that
they
are
sold
at
whatever
the
prevailing
first
class
rate
is
at
the
time
of
 sale,
but
are
accepted
for
first‐class
postage
when
they
are
used.

Thus,
if
one
 purchased
the
forever
stamp
when
the
first‐class
postage
was
$0.42
it
could
be
used
at
 the
higher
rate
of
$0.44

which
started
yesterday.
 4.1a
 When
the
postage
rate
increased
yesterday
(May
11,
2009)
what
is
the
rate
of
return
 you
earned
if
you
had
purchased
$4,200
of
forever
stamps
on
May
11,
2008?

Show
all
 your
calculations.

(five
points)
 return =
 cash received - Δprice 


 original price € In this case there is no cash received. The first price is $4,200. The new price is $4,400, so the change in price is $200 with an original price. The return is, then: $200 = 0.0476 = 4.76% 
 
$4, 200 
 
 € 4.1b
 According
to
the
Federal
Reserve
you
could
have
earned
a
return
of
2.06%
if
you
had
 bought
a
one‐year
US
Treasury
security
in
May
2008
and
held
it
to
maturity.

There

is
 no
risk
of
default
for
either
the
stamps
and
the
treasury
security.

Why
would
you
most
 likely
put
your
$4,200
in
the
US
Treasury
security
than
in
forever
stamps?

(five
points)

 While you would be earning more with the stamps (4.76%) than with the UST (2.06%), the advantage of the UST is that it is more liquid. Since there is not a secondary market for stamps you will have trouble selling the stamps and receiving the return. The UST upon maturity can be redeemed easily. 
 4.2
 The
United
States
has
imposed
a
restriction
on
trade
and
investment
in
Cuba
since
 February
1962.


The
two
countries’
financial
systems
are
completely
separate
and
 funds
do
not
flow
between
them
to
finance
investment.

Compared
to
the
US,
Cuba
is
 underdeveloped,
with
little
investment
occurring
over
the
last
forty‐five
years
and
 limited
domestic
funds
and
small
amounts
of
accumulated
wealth.

The
US
economy
is
 mature.

Because
of
the
lack
of
investment
over
almost
a
half
century
in
Cuba,
the
US
 has
fewer
new
investment
opportunities
than
Cuba
and
but
the
US
has
larger
amounts
 of
wealth.


 4.2a
 Using
the
bond
market
model
developed
in
class
would
the
interest
rates
be
higher
in
 Cuba
or
the
US
if
investment
in
both
places
is
funded
mostly
through
bonds.


A
graph
 and
an
explanation
would
be
useful
in
answering
this
question.
(three
points)
 
 4.2b
 Use
the
model
of
the
bond
market
to
predict
what
would
happen
to
the
interest
rates
 in
both
countries
if
the
embargo
was
lifted
and
funds
could
flow
without
restriction
 between
Cuba
and
the
US?

(four
points)
 Since the interest rates are higher in Cuba than in the US, we will expect that capital will flow out of the US to Cuba. This will increase the demand for bonds in Cuba and decrease the demand for bonds in the US. The decrease in demand for bonds in the US will cause the price of bonds to drop in the US and in Cuba bonds will increase in price. This, in turn, means interest rates will increase in the US will decrease in Cuba. The graphs below show this. D’ D’ rUS’* r rc’* If the liberalization of the embargo allows for direct investment (i.e., American firms can invest in Cuba) then the supply of bonds in the US may increase as US firms look to finance expansion in Cuba by selling bonds. This will make the interest rate in the US rise even more than the above graphs would indicate since the S of bonds in the US will increase. 4.2c
 Would
more
profitable
investment
projects
be
financed
and
undertaken
if
the
embargo
 is
lifted?

Why
or
why
not?

(three
points)
 Yes, more profitable investment would be available in Cuba and these would be undertaken in place of less profitable US investments that would have been made with the embargo in place ...
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This note was uploaded on 09/27/2009 for the course ECON 160 taught by Professor Baim during the Spring '98 term at UCLA.

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