Monetary Theory and Policy
M. Finkler
Fall 2005
Final Exam
Answer question one (30 points) and six of the remaining questions (20 points each);
thus, the maximum possible score would be 150 points. You may not use any objects –
animate or inanimate (except for a calculator, writing instruments, and paper) – to assist
you in this exam. The exam is due 3 hours after you receive it from me. The Honor
Code is in effect.
“Financial commentators and central bankers have labeled the failure of long-term rates
to rise in the face of an upward trending federal funds rate a ‘conundrum’ [puzzle]… In
fact, a common benchmark holds that simple market forces should make long-term rates
a weighted average of the short-term interest rates expected to prevail during the period
covered by the bond.” - M. Guidolin
1.
The stock of money in circulation depends upon bank and the non-bank
public’s decision-making as well as the monetary policies of the central bank.
Use the following data (in million $) for Bank A to answer this question.
Assets
Reserves, R
Loans, L
Securities, S
Total
50
300
180
530
Liabilities
Checkable Deposits, D
Time Deposits, T
Net Worth, NW
Liabilities plus Net Worth
300
200
30
530
For the economy as a whole, the initial level of D = $2 trillion, and the
relevant ratios for other components are as follows:
Currency-Deposit Ratio (C/D)
=
0.25
Small Time Deposit-Checkable Deposit ratio (T/D)
=
2.00
Retail Money Market – Checkable Deposit ratio (MM/D) =
0.50
Excess Reserve – Deposit ratio (ER/D)
=
0.05
Required Reserve – Deposit ratio (RR/D)
=
0.10
a.
b.
c.
d.
Calculate the monetary base (M0), M1, and M2.
Determine the M1 and M2 monetary base multipliers.
Determine the amount of Bank A’s excess reserves.
Suppose the Fed raises the required reserve ratio to 0.12 and that no banks
hold excess reserves. What happens to M1 and M2? What happens to
Bank A’s balance sheet?
e. Suppose the Fed buys $10 billion in U.S. Securities from the open market
including $150 million from Bank A. What happens to A’s balance sheet?
To the Monetary Base? To M2, given the answer in part b.
2.
The term structure of interest rates
a. Why is the current term structure of interest rates referred to as a
“conundrum” (in the quotation at the beginning of the exam)?
b. What does the expectations theory of the term structure predict about the
term structure?
c. What common characteristic of the term structure does the expectations
theory not account for?
d. What economic circumstances might yield a downward sloping term
structure? Explain.
3.
In reference to a gold standard, William Jennings Bryan argued that, “You
shall not press down upon the brow of labor this crown of thorn. You shall not
crucify mankind on a cross of gold.”
a. Explain how a gold standard works.
b. What are the implications of a gold standard for countries that run a
balance of payments deficit? Surplus?
c. Name one key way that a currency board is similar to a gold standard.
d. Name one key way that a currency board differs from a gold standard.
4.
Many economists argue that monetary authorities need an anchor for
monetary policy.
a. Indicate one argument in favor of and one argument against exchange rate
targeting.
b. Indicate one argument in favor of and one argument against money
aggregate targeting.
c. Indicate one argument in favor of and one argument against inflation
targeting.
d. Indicate one argument in favor of and one argument against implicit or no
explicit targets.
5.
Why do people hold money?
a. Explain Keynes’s liquidity preference view.
b. Explain the Tobin-Baumol inventory view.
c. Explain how knowledge about the demand for money function can affect
the selection of a monetary policy instrument.
d. Why might the predictions about the demand for money be accurate for
one period but way off target in a second period?
6.
Monetary Policy Instruments
a. Explain and illustrate how targeting a monetary aggregate (such as M1 or
M2) can result in interest rate instability.
b. Explain and illustrate how targeting interest rates can result in fluctuations
in monetary aggregates.
c. Explain how targeting interest rates can result in inflation that spirals out
of control.
7.
The Iron Triangle
a. Explain how the “iron triangle” constrains monetary policy makers.
b. If a country has an “undervalued” currency but wishes to keep its existent
fixed exchange rate, what choices does it have? What consequences
would you advise the country to consider as it assesses these choices?
c. Some economists (e.g., Jeffrey Sachs) have argued that countries should
just allow their exchange rate to float while others (e.g., Ronald
McKinnon) suggest that a “fear of floating” would be rational. What
should a country consider in deciding whether to allow its currency to
float?
8.
The Great Depression
a. The monetary base in the United States increased by 20% from 1929 to
1933, but the M1 aggregate fell by 25%. Explain how this could occur.
b. Show how a rise in the currency-deposit ratio affects the money multiplier
for M1.
c. What did the Fed do during the week following September 11, 2001 to add
liquidity to the marketplace?
d. Would the Fed’s actions on 9/11/01 have worked during the Great
Depression? Explain.
9.
The Interest Rate Parity Condition
a. State the interest rate parity condition (assume two countries: A and B)
b. Explain and illustrate what happens to its exchange rate if Country A
chooses to expand the growth rate of its stock of money.
c. If a “Bretton Woods” type agreement between the two countries exists,
explain and illustrate the effect of monetary expansion in Country A.
d. Could Country B sterilize its currency under the circumstances in b? c?
Explain.
10.
Exchange rates and “drunken sailors.”
a. Explain how central bank intervention in the currency market parallels
open market operations.
b. Define purchasing power parity exchange rates.
c. Indicate two reasons why purchasing power parity exchange rates often
deviate from observed exchange rates.
d. What is the “drunken sailor” analogy for the behavior of exchange rates?
In what way does this analogy help guide exchange rate policy?