2a) An important way in which the Federal Reserve decreases the money supply is by selling bonds to the public. Using a supply and demand analysis for bonds, show what effect this action has on interest rates. Answer: When the Fed sells bonds to the public, it increases the supply of bonds, thus shifting the supply curve BS to the right. The result is that the intersection of the supply and demand curves BS and Bd occurs at a lower equilibrium bond price and thus a higher equilibrium interest rate, and the interest rate rises. b) Calculate the duration of a 1,000, 6% coupon bond with three years to maturity. Assume that all market interest rates are 7% Answer: Year 1 2 3 Sum Payments 60. 00 60. 00 1060. 00 PV of Payments 56. 07 52. 41 865. 28 973. 76 Time Weighted PV of Payments 56. 07 104. 81 2595. 83 Time Weighted PV of Payments 0. 06 0. 11 2. 67 2. 83 of divided by price This bond has a duration of 2. 83years. Note that the current price of the bond is $973. 6, which is the sum of the individual “PV of payments”. 3a) What incentives arise for a central bank to fall into the time-inconsistency trap of pursuing overly expansionary monetary policy? Answer: Central bankers might think they can boost output or lower unemployment by pursuing overly expansionary monetary policy even though in the long run this just leads to higher inflation and no gains on the output or unemployment front. Alternatively, politicians may pressure the central bank to pursue overly expansionary policies. 3b) Which goals of the Fed frequently conflict?
Answer: The goal of price stability often conflicts with the goals of high economic growth and employment and interest rate stability. When the economy is expanding along with employment, inflation may rise. In order to pursue the goal of price stability the Fed may have to pursue contractionary anti-inflationary policy that conflicts with the goals of high employment and economics growth. Similarly when the central bank wants to pursue tight monetary policy and raise interest rates in order to contain inflation, this pursuit of the goal of price stability may conflict with the goal of interest-rate stability. Banks’ holding of deposits in accounts with the Fed, plus currency that is physically held in banks are called reserves. 2 If the Fed uses the federal funds rate as an interest rate target, fluctuations in the reserves demand curve will cause non-borrowed reserves to fluctuate. 3 A borrower who takes out a loan usually has better information about the potential returns and risk of the investment projects he plans to undertake than does the lender. This in equality of information is called asymmetric information. 4 Intermediaries who are agents of investors and match buyers with sellers of securities are called dealers. Intermediaries who link buyers and sellers by buying and selling securities a stated prices are called dealers. 6 A bond is a long-term security that promises to make periodic payments called dividends to the firm’s residual claimants. 7 In financial markets, lenders typically have inferior information about potential returns and risks associated with my investment project. This difference in information called asymmetric information. 8 A loan that requires the borrower to make the same payment every period until the maturity date is called a fixed-payment loan A bond’s future payments are called its cash flows 10 A credit market instrument that pays the owner the face value of the security at the maturity date and nothing prior to then is called a discount bond. 11 The riskiness of an asset’s return that results from interest rate changes is called interest –rate risk. 12 The average lifetime of a debt security’s stream of payment is called duration. 13 When the lender provides the borrower with an amount of funds that must be repaid to the lender at the maturity date, along with an additional payment for the interest, it is called a simple loan 4 The theory of purchasing power parity states that exchange rate between any two currencies will adjust to reflect changes in the price levels of the two countries 15 The starting point for understanding how exchange rates are determined is a simple idea called the law of one price, which states that if two countries produce an identical good, the price of the good should be the same throughout the world no matter which country produces it. 16 The problem created by asymmetric information before the transaction occurs is called adverse selection , with the problem created after the transaction occurs is called moral hazard. 7 The New York Fed bank, with about 25 percent of the system’s assets, is the most important of the Federal Reserve banks. 18 If borrowers take on big risks after obtaining a loan, then lenders face the problem of moral hazard. 19 Each member of the seven-member board of governors is appointed by the president and confirmed by the senate to serve 14 year terms. 20 The Federal Reserve entity that determines monetary policy strategy is the Federal Open Market Committee.