MIDTERM EXAM I - Money & Banking - FALL 2000

For maximum credit: write legibly in full sentences, label all numbers with appropriate units, show all work to get maximum partial credit.  Essays and
True-False-Uncertain/Explain questions should be answered with at least one full paragraph.  Points are indicated in parentheses, 70 points total. Good Luck!

ESSAY QUESTIONS - WRITE A MINIMUM OF ONE FULL PARAGRAPH

1.  (10 points) Evidence shows that interest rates are procyclical (interest rates rise during economic expansions, and fall during economic contractions).  Explain the statement above using either the S & D for Bonds or the S & D for Credit model in your answer, showing what happens to interest rates both during an expansion and during a contraction.

2.  (10 points) Assume the Federal Reserve implements expansionary monetary policy by performing an open market operation (buying bonds from the public).
a.  Using both the S and D for Bonds model and the S and D for Money model, graphically show the initial “liquidity effect” of expansionary monetary policy and explain in words what happens to interest rates initially (Short run).
b.  Show what most often happens to interest rates over time (Long run) as a result of expansionary monetary policy, with a detailed diagram and discussion.

3.  (10 points) T-F-Uncertain/Explain.  State an answer (T, F or U) and then completely explain your answer in a short essay of a minimum of one full paragraph.  “When the actual rate of inflation is greater than the nominal interest rate, the real rate of interest will be negative.”

PROBLEMS - SHOW ALL WORK TO RECEIVE FULL CREDIT, and LABEL ALL NUMBERS WITH APPROPRIATE UNITS!!

1. (30 points total, as indicated) You are given the following information on bonds in the year 2000 when the CPI is 170.  Assume coupon annual coupon payments.

Type                        Coupon Rate           FV             Term           Price

Zero Coupon                    ---               \$1000         10 years          \$495
Regular T-bond              6%                \$1000           5 years          \$975
Indexed T-bond             3.5%             \$1040           5 years           \$1025
Municipal bond             4.75%            \$1000           5 years            \$985

a. calculate the yield to maturity (YTM) for each of the four bonds above. (6 points)
b. Calculate the current yield (PMT /Price ) for each bond above except the zero coupon bond (quote the current yield to 2 decimal places, e.g. 5.28%).  (6 points)
c. use the information above and calculate the expected rate of inflation over the next five years.  Explain your answer in a short essay.  (6 points)
d. Use your answer from part c, and assume the CPI in 2005 is 182.  Calculate the and state the actual rate of inflation over the next five years.  Would a person who bought the Regular T-bond in 2000 and held it until maturity be helped or harmed by the actual rate of inflation?  Why or why not?  Explain in a short essay.  (6 points)
e. assuming that Regular T-notes are fully taxable, would a person in the 26% tax bracket prefer the municipal bond (tax-free) or the Regular T-bond?  Explain your answer and show calculations to support your answer.  (Assume that there is no difference in default risk) (6 points)

2. (10 points total, 2 points for each part ) Given the data below:
a. Calculate the annualized, compounded nominal rate of return for each country’s stock index over this period using the time value of money formula.
b. Calculate the annualized, compounded rate of inflation in each country.
c. Calculate the real rate of return for each stock market.
d. Which country had the highest nominal return?
e. Which country had the highest real return?  Explain your answer in words in a short essay.

YEAR                              1990       1996
Germany    Stock Index     650          1825
CPI                 622           988

Italy          Stock Index    2000          9725
CPI                998           3200