Money and Banking
ECON 354
Prof. Yamin Ahmad
Spring 2007
Midterm Exam # 1
Name___________________________________
Id # _______________________
Instructions: There are two parts to this midterm. Part A consists of multiple choice
questions. Please mark the answers to the multiple choice questions on the exam paper
and fill in the relevant bubble on the Scantron sheet. Part A is worth 60%.
Part B is worth 40% and consists of short answer questions. Please answer in the space
provided. Please attempt both parts and turn the exam in at the end.
MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question.
1) When the price of a consol paying $1 annually is $20, the interest rate is
A) 1 percent.
B) 2 percent.
C) 5 percent.
D) 20 percent.
E) 4 percent.
Answer: C
2) The four players in the money supply process include
A) banks, depositors, the central bank, and the U.S. Treasury.
B) banks, borrowers, the central bank, and the U.S. Treasury.
C) banks, depositors, the central bank, and borrowers.
D) banks, depositors, borrowers, and the U.S. Treasury.
Answer: C
3) The monetary base consists of
A) currency in circulation and reserves.
B) currency in circulation and discount loans.
C) reserves and government securities.
D) currency in circulation and Federal Reserve notes.
E) currency in circulation and government securities.
Answer: A
4) The current yield on a $10,000, 5 percent coupon bond selling for $5,000 is
A) 12.5 percent.
B) 5.0 percent.
C) 10.0 percent.
D) 7.5 percent.
Answer: C
5) When the Federal Reserve _____ a government bond in the open market, reserves in the banking system _____.
A) purchase; decline
B) purchases; increase
C) sells; increase
D) purchase; remain unchanged
Answer: B
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6) Which of the following is not an entity of the Federal Reserve System?
A) Federal Reserve Banks
B) The Federal Open Market Committee
C) The Board of Governors
D) The Comptroller of the Currency
E) None of the above
Answer: D
7) The Federal Open Market Committee consists of
A) the seven members of the Board of Governors and five presidents of the regional Fed banks.
B) the seven members of the Board of Governors and seven presidents of the regional Fed banks.
C) the five senior members of the seven-member Board of Governors.
D) the twelve regional Fed bank presidents and the chairman of the Board of Governors.
Answer: A
8) Which of the following are true of fixed payment loans?
A) The borrower repays both the principal and interest at the maturity date.
B) Installment loans and mortgages are frequently of the fixed payment type.
C) The borrower repays the loan by making the same payment every month.
D) Both A and B of the above.
E) Both B and C of the above.
Answer: E
9) An assetʹs interest rate risk _______ as the duration of the asset _____.
A) increases; decreases
B) remains constant; increases
C) decreases; decreases
D) remains constant; decreases
E) decreases; increases
Answer: C
10) Federal Reserve Assets include
A) Treasury securities.
B) Treasury deposits.
C) discount loans.
D) both A and B of the above.
E) both A and C of the above.
Answer: E
11) For a 3-year simple loan of $10,000 at 10 percent, the amount to be repaid is
A) $10,333.
B) $13,000.
C) $13,310.
Answer: C
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D) $10,030.
E) $10,300.
12) The _____ is a better approximation for the _____, the nearer the bondʹs price is to the bondʹs par value and the
longer the maturity of the bond.
A) yield to maturity; current yield
B) yield to maturity; coupon rate
C) current yield; coupon rate
D) current yield; yield to maturity
Answer: D
13) If a $20,000 coupon bond has a coupon rate of 5 percent, then the coupon payment every year is
A) $50.
B) $100.
C) $1000.
D) $500.
Answer: C
14) The evolution of the payments system from barter to precious metals, then to fiat money, then to checks can
best be understood as a consequence of
A) the fact that precious metals were not generally acceptable.
B) innovations that allowed individuals to escape oppressive taxes.
C) the fact that precious metals were difficult to carry and transport.
D) the fact that paper money is less accepted than checks.
E) the fact that paper more costly to produce than precious metals.
Answer: C
15) Which of the following are true for the current yield?
A) The formula for the current yield is identical to the formula describing the yield to maturity for a discount
bond.
B) The current yield is defined as the yearly coupon payment divided by the price of the security.
C) The current yield is always a poor approximation for the yield to maturity.
D) All of the above are true.
E) Only A and B of the above are true.
Answer: B
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Part B: SHORT ANSWER QUESTIONS (40%)
Write brief answers to the questions below being as succinct and clear as
possible. Show any calculations as necessary in answering the questions.
Note: You will not receive full credit for just simply writing down the answer,
without showing any working!
21. (20%) Recall in class that we mentioned money serves three roles: Medium
of exchange, Unit of Account and Store of Value.
a. (3pts) Money as a Unit of Account: Consider the table below.
Item
Relative Price
Plasma TV
3 Playstation 3s
Playstation 3
6 Bulls Tickets
Ticket to a Bulls Game 2 Microwaves
Microwave
2.5 DVDs
DVD Movie
Calculate the rate at which Plasma TVs will exchange for DVD movies.
Answer:
1 Plasma TV = 3*6*2*2.5 DVD movies = 90 DVD movies
Therefore: 1:90
b. (4 pts) In part (a) where we examined 5 goods, we would need to know 10
pairs of relative prices in order to know how all the goods were valued in
terms of each other. Suppose we were in an economy with 6 goods. How
many pairs of relative prices would we need to know in order to be able to
value the goods and services?
Answer:
To solve this, we need to calculate the number of pairs that can be achieved from
six goods. That is, we can use combinations to solve for it, i.e.
6!
6
= 15
C2 =
4!2!
[Alternatively, you can look along the third diagonal of a Pascal Triangle and by
counting along the diagonal to the 6th position, yields 15.]
c. (3 pts) Consider that money serves as a form of transactions technology
within a medium of exchange. Define an equation which links money to the
transaction services it provides under this role. What is the key assumption in
this equation?
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Answer: MV=T where M is money supply, V is velocity (assumed constant) and
T is number of transactions.
The key assumption here is that velocity is constant, i.e. the rate at which
dollars get turned over in the economy remains constant.
d. (4 pts) Suppose in the economy of Asuras, the economic growth rate is 4%
and inflation is predicted to be 3%. However cuts in transaction costs at ATM
machines this year increased the velocity of money by 1%. What rate of
money growth should the Asuran central bank target in order to achieve the
3% inflation rate? [Hint: Think about the Quantity Equation and how we go
from the equation itself to growth rates. In particular think about whether the
assumptions we posed in classes are valid for this scenario].
Answer:
From the Quantity equation:MV = PY we obtain:
ΔM ΔV ΔP ΔY
+
=
+
V
P
Y
M
ΔM
ΔV
=π + g −
Hence,
M
V
= 3% + 4% − 1% = 6%
e. (6 pts) For the scenario below, show how the following open market operation
by the Fed impacts the banking sector and the economy, using T-Accounts.
Scenario: The fed buys $10000 of securities from John Doe and pays for it
with a check. Mr Doe promptly cashes the check and holds on to the money
for a rainy day. What is the impact on reserves in the banking system? What
is the impact on the monetary base?
Answer:
John Doe
Assets
Federal Reserve
Liabilities
Assets
Securities +$10000
Securities -$10000
Liabilities
Currency +$10000
Currency +$10000
Hence, there is no impact on reserves. Currency in circulation increases and
therefore monetary base increases.
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23.
(20%)
Suppose you are faced with the option of purchasing Asset A: a five-year
Treasury note with a $1,000 face value and a 5% coupon rate.
a. (3 pts) Calculate the coupon payment you receive if you purchase this fiveyear Treasury note (Asset A).
Answer: Coupon payment = $1000 x 0.05 = $50
b. (6 pts) Assume the yield to maturity of Asset A, the Treasury note, equals 4%.
Compute the price of this five-year Treasury note. [Hint: Use the coupon
payment calculated in part (a) above and the yield to maturity to find the
present discounted value of the entire stream of payments.]
Answer:
50
50
50
50
50
1000
+
+
+
+
+
2
3
4
5
1.04 1.04 1.04 1.04 1.04 1.045
⎛ 50 ⎞
⎜
⎟
50 ⎝ 0.04 ⎠ 1000
≡
−
+
(using the perpetuity calcuation given in class)
0.04 1.045 1.045
= 1250 − 1027.41 + 821.93
= 1044.52
Price =
c. (4 pts) Suppose that the yield to maturity rises from 4% to 6%. Calculate the
new price of the five-year Treasury note. [Hint: Repeat what you did for parts
(a) and (b)]. Given your answer to part (b), what do you notice about the
correlation between the price of the bond and the yield to maturity?
Answer:
Using the same method as above to find the price, we get: P = $957.08
What we observe is the negative relationship between the yield to maturity and
the price. As the yield to maturity increases, the price decreases, i.e. if the yield
to maturity is less than the coupon rate, the price is greater than the face value. If
the yield to maturity is higher than the coupon rate, the price is lower than the
face value.
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d. (3 pts) Consider a similar asset to that above, Asset B: a 15 year Treasury
note with a $1000 face value and a 5% coupon rate. Suppose that we do not
know what the true yield to maturity is. However, the current price for this
security is $750. Calculate the current yield for Asset B to 2 decimal places.
Answer:
Current Yield, i c =
C $50
=
= 6.67% = 6 23 %
P $750
e. (2 pts) The current yield on which asset, Asset A or Asset B would be a better
predictor for the true yield to maturity?
Answer: Asset B since the more the asset resembles a perpetuity, the closer the
current yield (which is basically calculating the yield on an asset as if it were a
perpetuity) will be to the true yield to maturity. Asset B offers more payoffs
and has a closer representation of a payoff structure that matches a
perpetuities payoff structure.
f. (2 pts) Suppose exogenous factors in the financial markets cause the current
yield for Asset B to change to 8%. What impact do you think this will have on
the price of Asset A?
Answer: If an exogenous factor in the market causes a change in the current
yield, increasing it from 6.67% to 8%, then changes in the current yield signal
changes to the true yield to maturity in the same direction. This indicates that
the true yield to maturity has increased. This would imply that the price of
asset A, which is the PDV of its stream of payoffs would fall.
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