Money and Banking
Homework Assignment #2 Spring 2014
1. You have extra money lying around and you want to do something with it but don’t want to take on
any risk. You find that you have a choice between a no risk mutual fund that is a mix of CDs and
corporate bonds which yields 5% annually and a 3 year US treasury bond. The bond has a face value of
$2000. What is the highest price you would pay for the treasury bond?
2. Imagine a simple economy of Freedonia that uses gold as its currency (only gold, not gold backed
paper). Suppose that Freediona finds itself deeply in debt and that its creditors who all live in the
country of Sylvania demand the repayment of debt in gold. What is likely to happen to prices in
Freedonia? What is likely to happen to the economy? You should use the quantity theory of money—as
well as your own powers to reason—to think about this question.
3. How much is a $1000 bond that will mature in 3 years worth today to you if the interest rate is 6%
4. If the Federal government were able to—in a reasonable and rational way—reduce the US deficit
what would happen to the equilibrium price, yield and quantity of bonds. Assume there is a single
market for all bonds.
2. Suppose the Sequester (of last year) caused a mild recession. Ignoring the fact that interest rates are
already at zero, what could the Federal Reserve do to offset the decline in output. What affects will this
have on the economy and on interest rates? Are they likely to be successful at countering the recession
in the short run? Are they likely to be successful in the long run? Why?
3.
a. What is counted as the monetary base? Who controls the monetary base?
b. What is included in M2?
c. What is included in the monetary base but not in M2? What is included in both?
4. What should happen to the equilibrium price, interest rate, and quantity of bonds today if people
expect that these bonds will be worth half as much in the future? Use the simplified model of the bond
market we developed in class. A complete answer will include both a graph and a brief written
explanation.
5. Suppose that the collapse of two large financial institutions within a year cause a stock market crash
and causes expectations about the future of the economy to fall significantly (sound familiar?). Most of
the questions require a graph. Some questions require more than one graph.
a. What should happen to the equilibrium price, interest rate and quantity of bonds in the bond market,
assuming there is only one kind of bond.
b. What can the Federal Reserve do to help offset the recession? Show both what the Fed can do and
5explain what will happen to the aggregate economy.
c. Is it obvious that the Fed can be successful in offsetting the recession? What “effects” on the interest
rate work for and against the Fed? Draw separate graphs to illustrate each effect.
6. The Chinese have weathered the global economic crisis remarkably well. In fact while most countries
are still keeping their interest rates very low China's central bank The People's Bank of China (PBC)
recently raised interest rates in order to help curb was it sees as a rising inflationary problem.
a. Using the liquidity preference framework explain how the PBC will do this. Why do they do this and
what is the intended effect on the economy?
b. If the PBC is successful at curbing inflation what should happen to the global bond market? Use the
simplified bond market we developed in class.
c. After the PBC changes monetary policy to lower inflation what other things are likely to change in the
market for money?