Name: ____________________
Student ID: ____________________
Midterm Exam
Economics 333
Money and Banking
Thursday, October 22rd , 2009
Write all of your answers on this exam sheet. Do not turn in the blue book.
Multiple Choice (2.5 pts each)
1. The central bank purchases foreign currency in the foreign currency market. To
conduct a sterilized intervention, the central bank must
a. Increase discount window lending.
b. Cut its interest rate target.
c. Sell government securities to domestic banks
d. Reduce domestic reserve requirements.
______C__________
2. A central bank has an operating target for the interbank interest rate. As a mater of
policy the central bank decides to temporarily cut its interbank interest rate
targets. This will
a. Reduce the level of commercial bank reserves and depreciate the exchange
rate.
b. Reduce the level of commercial bank reserves and appreciate the exchange
rate.
c. Increase the level of commercial bank reserves and depreciate the
exchange rate.
d. Increase the level of commercial bank reserves and appreciate the
exchange rate.
________C_______
3. The yield curve in the US ((the spread between 10 year Treasury bonds and 1 year
Treasury Bills) is positive, as is standard. The US government increases its
defense spending increasing demand for goods in the US. The Federal Reserve
operates monetary policy according to the Taylor rule and will maintain a fixed
inflation target.
a. A rise in Hong Kong’s real interest rate and a flatter yield curve.
b. A fall in Hong Kong’s real interest rate and a flatter yield curve.
c. A rise in Hong Kong’s real interest rate and a steeper yield curve.
d. A fall in Hong Kong’s real interest rate and a steeper yield curve.
___________A____
4. The US Federal Reserve Bank instructs its traders to maintain a certain interest
rate target. Commercial banks decide the operating environment is less risky and
decide to hold less liquid reserves. To maintain the interest rate target, the traders
will engage in:
a. Outright open market sales if the change in reserve holdings is perceived
to be temporary and repo operations if the change is perceived to be
permanent.
b. Outright open market sales if the change in reserve holdings is perceived
to be permanent and repo operations if the change is perceived to be
temporary.
c. Outright open market sales if the change in reserve holdings is perceived
to be temporary and reverse repo operations if the change is perceived to
be permanent.
d. Outright open market sales if the change in reserve holdings is perceived
to be permanent and reverse repo operations if the change is perceived to
be temporary.
_______D________
5. Albonia and Balbonia are two countries that are exactly the same except for
having different monetary policies. Albonia has a fixed exchange rate with the US
dollar and Balbonia maintains a domestic interest rate target which is set to
stabilize the domestic inflation rate. A temporary cut in the Fed Funds rate will
a. Depreciate the Balbonian dollar relative to the US dollar and increase
Albonia’s money supply.
b. Depreciate the Balbonian dollar Won relative to the US dollar and reduce
Albonia’s money supply.
c. Appreciate the Balbonian dollar relative to the US dollar and increase
Albonia’s money supply.
d. Appreciate the Balbonian dollar relative to the US Dollar and reduce
Albonia’s money supply.
________C________
6. Albonia has a fixed exchange rate with the US dollar and Balbonia maintains a
real interest rate which rises when domestic inflation rises. We could say that:
a. GDP would decline more sharply in Balbonia than in Albonia if oil prices
rose and GDP would decline more sharply in Balbonia than in Albonia if
the domestic consumer confidence crashed.
b. GDP would decline more sharply in Albonia than in Balbonia if oil prices
rose and GDP would decline more persistently in Balbonia than in
Albonia if domestic consumer confidence crashed.
c. GDP would decline more sharply in Balbonia than in Albonia if oil prices
rose and GDP would decline more persistently in Albonia than in
Balbonia if domestic consumer confidence crashed.
d. GDP would decline more sharply in Albonia than in Balbonia if oil prices
rose and GDP would decline more persistently in Albonia than in
Balbonia if domestic consumer confidence crashed.
________C_______
Short-Answer Questions
7. (3 points) What is the convertibility undertaking? [Be as detailed as possible with
4 sentences or less]
The HKMA undertakes to purchase US dollars at a rate of 7.75 HK$ per US dollar
from commercial banks in exchange for clearing balances. The HKMA undertakes to
sell US dollars at a rate of 7.85 HK$ per US dollar to commercial banks in exchange
for clearing balances. This keeps the exchange rate in a narrow range near 7.8.
8. (2 points) In three sentences or less, what is the Taylor principle?
The Taylor principle is to adjust interest rates on a more than one-for-one basis with
inflation expectations so that real interest rates rise and fall with inflation
expectations.
9. (5 points) The central bank of New Zealand is the Reserve Bank of New Zealand
which is headed by an executive known as the Governor. The equivalent of the
Financial Secretary in New Zealand is known as the Treasurer. In 1989, the
Reserve Bank of New Zealand Act instituted some new rules governing central
banking. To quote the Reserve Banks’ website, “the legislation in 1989 reflected
the new approach …. intended to combine and balance operational independence
and democratic accountability.” The Reserve Bank Act has several points.





“The Act declares that the Reserve Bank's main function is ‘to
formulate and implement monetary policy directed to the
economic objective of achieving and maintaining stability in the
general level of prices’.”
“The Act requires that the Treasurer and the Governor agree to
and publish a precise specification of the inflation target, which
must be consistent with the goal of ‘stability in the general level
of prices’, this being known as the Policy Targets Agreement The
act provides specific rules by which the Treasurer may over-ride
the Policy Targets Agreement, though this must be done
publicly.”
“Responsibility for almost all Reserve Bank decisions and actions
lies explicitly with the Governor, as the institution's chief
executive
The parliament sets the funding level of the central bank.
Precise rules limit the circumstances in which the Government
can dismiss the Governor.”
List two characteristics that help strengthen the independence of New Zealand’s
central bank.
i. Governor has responsibility for monetary policy decisions
ii. Limited ability to fire the governor
Name one characteristic that weakens independence.
i. Parliament provides funding not independent sources.
Name one characteristic that strengthens democratic accountability.
i. Long-term policy goals clearly set out by Treasurer Governor and
legislature.
Calculations
10. (4 points) On January 1, 2007, the interest rate on one year US Treasury bills is
1% and the interest rate on 2 year Treasury bills is 2%. The interest rate on a one
year bond denominated in Korean Won is 7%. The spot exchange rate is 1000
won per dollar. Assume that interest parity and the expectations theory of the term
structure are true. Calculate the market’s expectation of the won-dollar exchange
rate and the 1 year U.S. Treasury rate on December 31st, 2007.
Expectations theory of the term structure is
i  iE
it ,2  t ,1 t 1,1  itE1,1  2  it ,2  it ,1  .04  .01  .03
2
tE1 
St 1  St
 it  itF  .07  .01  .06  St 1  1.06  St  1060
St
11. (3 points) The growth rate of real GDP (real output) in the economy averages 5%.
The target real interest rate of the central bank is 4%. Velocity is constant. What
is the average money growth rate at which average real returns on paper money
would be zero?
itCASH  0  rtCASH   t  gtY  gtM
A zero inflation rate would mean zero returns to cash. Growth rate of money
equal to 5% would set inflation at zero.
12. (3 points) Currently, the ratio of dividends to stock prices is .031. The interest rate
is i =.0173. Assume the interest rate and the growth rate of dividends remains
constant through the future. What growth rate for dividends would justify the
current stock prices?
1 g
Pt 
Dt  That depending on the equity premium, many growth rates will
i  eqp  g
be consistent.
13. (4 points) The interest rate target of the Bank of Korea is assumed to follow a
Taylor rule as in the USA.
itTGT  .025   t  1 2  Inflation Gapt  1 2  Output Gapt
Korea, however, might potentially have a different inflation target than the US.
Assume that the average of the Inflation Gap in Korea is zero and the average of
the Output Gap is zero. The average of the targeted interest rate is 4.2%.
a. What is the implied inflation target for Korea?
If the average inflation gap is zero, then the average inflation is the target
inflation rate. The average interest target would then be
Average itTGT  .025   TGT  .042   TGT  .017
b. Currently the average output gap is -.6% (i.e. Output Gap = -.006), the current
inflation rate is 2.16%. What interest rate should be set in Korea according to
the Taylor rule?
The interest rate should be
itTGT  .025   t  1 2  ( t   TGT )  1 2  .006
 .025  .0216  1 2  (.0216  .017)  .003
 .0466  1 2  (.0046)  .003  .0466  (.0023)  .003
 .0466  .0007  .0459
14. (3 points) The monetary base is $100. The central bank imposes a required
reserves ratio of 25% of demand deposits. The ratio of currency to demand
deposits is .5. Assuming no excess reserves, calculate M1. Holding the level of
reserves constant, what should the central bank set the reserve ratio at if it wants
to increase M1 to $250?
1
.5  1
D

 2 . M1 is 200. The money multiplier is 2.5
C R
.5  .25
D
D
.5  1
1.5
so
 2.5  .5  R 
 .6  R  .1
D
D
R
2.5
.5 
D
C
The money multiplier is
Tables and Charts
15. (3 points) The Hong Kong Monetary Authority sells $100 in Exchange Fund bills
to Hong Kong banks in exchange for reserves in their clearing balances. Describe
this transaction with a T-account of the HKMA and an example Hong Kong bank.
What is the total change in the monetary base?
Commerical
Bank
Assets
Liabilities
+100 Ex Fund Bills
-100 Reserves
HKMA
Assets
Liabilities
+100 Ex Fund Bills
-100 Reserves
No Change in the Monetary Base
16. (5 points) Financial markets suddenly come to believe that the Hong Kong dollar
will be increase in value relative to the US dollar in the future. Using graphs of
the interbank reserves market, demonstrate the effects of this event on HIBOR,
and clearing balances.
iHIBOR
iFF
iFF'+η
Demand for Reserves
Clearing Balances
η<0
(5 points) Economic forecasters at the domestic central bank detect a rise in expected
inflation. The central bank responds according to the Taylor principle. Draw a graph
demonstrating the effect of the central bank’s actions on the forex rate.
S
S
S’
S*
S**
D
D’
17. (5 points) The central bank of Ruritania sets allows banks to deposit their
reserves at a 2% interest rate. Currently, the equilibrium interbank rate in
Ruritania is 2%. The central bank of Ruritania engages in a large (unsterilized
purchase of foreign currency assets). Draw a picture of the interbank market to
demonstrate the outcome of this action:
iIBOR
D
S
S’
Commercial
Bank Reserve