Name: ____________________
Student ID: ____________________
Midterm Exam
Economics 333
Money and Banking
Tuesday, October 24th, 2006
Write all of your answers on this exam sheet. Do not turn in the blue book.
Multiple Choice (4pts 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. Presuming that the increase in spending is temporary, we should
expect to see:
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. Hong Kong has a fixed exchange rate with the US dollar and Korea 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 Korean Won relative to the US dollar and increase Hong
Kong’s money supply.
b. Depreciate the Korean Won relative to the US dollar and reduce Hong
Kong’s money supply.
c. Appreciate the Korean Won relative to the US dollar and increase Hong
Kong’s money supply.
d. Appreciate the Korean Won relative to the US Dollar and reduce Hong
Kong’s money supply.
___________C_____
6. Hong Kong has a fixed exchange rate with the US dollar and Korea maintains a
real interest rate which rises when domestic inflation rises. We could say that:
a. GDP would decline more sharply in Korea than in HK if oil prices rose
and GDP would decline more persistently in Korea than in HK if the
domestic stock market crashed.
b. GDP would decline more sharply in HK than in Korea if oil prices rose
and GDP would decline more persistently in Korea than in HK if domestic
stock market crashed.
c. GDP would decline more sharply in Korea than in HK if oil prices rose
and GDP would decline more persistently in HK than in Korea if domestic
stock market crashed.
d. GDP would decline more sharply in HK than in Korea if oil prices rose
and GDP would decline more persistently in HK than in Korea if domestic
stock market crashed.
_______C or B____
Arguably, if the high oil prices affected the US, the rise in the US rate might affect
HK to the same degree as Korea, so B was accepted.
Short-Answer Questions
7. (6 Points) Identify the Following Acronyms
a. ZIRP
Zero Interest Rate Policy of the Bank of Japan keeping its interest rate target
at 0
b. SAFE State Administration of Foreign Exchange, the PRC department
which buys and sells foreign exchange
c. FOMC Federal Open Market Committee which sets the Fed Funds target
of the Federal Rerserve Bank
8. (10 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.
9. ((10 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. (10 points) A 10 year coupon bond has a face value of 100 and a coupon rate of
10%. If the yield to maturity on the bond is 5%, what is the price?
The price is
P
C 
1
 1 
i  (1  i )T
 FACE 10 
1
100

  (1  i)T  .05  1  1.628894627   1.628894627  138.6086746



11. (10 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 covered 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
12. (10 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. What should the
central bank set the reserve ratio at if it wants to increase M1 to $250?
C 1
.5  1
D

 2 . M1 is 200. The money multiplier is 2.5
The money multiplier is
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
Some people answered as if C was fixed rather than C/D. If C/D is .5 and R/D is .25, then
C = 2R so C = 66.66. and R = 33.33. If M1 is to go to 250, then D would have to equal
183.33. With R equal to 33.333, the R/D would have to be 0.1818. This answer was also
accepted.
Geometry and Other Skills
13. (10 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?
HKMA
Assets
Liabilities
+100 Ex Fund Bills
-100 Reserves
Commerical
Bank
Assets
+100 Ex Fund Bills
-100 Reserves
No Change in the Monetary Base
Liabilities
14. (10 points) Financial markets suddenly come to believe that the Hong Kong dollar
will be devalued 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. Assume that the expected depreciation rate of the Hong Kong
dollar is large (greater than 500 basis points). In one paragraph or less, explain
what is likely to happen to discount window borrowing.
iHIBOR
iFF'+η
iFF
Demand for Reserves
Clearing Balances
If the domestic interbank interest rate rises above the discount window rate, banks
will borrow from the discount window. In HK, the discount window rate is a markup,
no more than 500 points more than the Fed Funds rate.