EXAMINATION I - MONEY & BANKING - WINTER 2000

For maximum credit: write legibly in full sentences, label all numbers with appropriate units, show all work.  Essays and T-F-U/Explain questions should be answered with at least one full paragraph.  The exam is worth 75 points, and five extra credit points are included (80 points total).  Points are indicated in parentheses.

ESSAYS
1. (10) The Federal Reserve has raised interest rates four times in the last year to slow down the economy, and yet the economy continues to experience strong growth.  Give several reasons (with explanations) why the interest rate increases have failed to slow down the economy.

2. (10) Several weeks ago, the Federal Reserve raised its target rate for the Federal Funds rate from 5.5% to 5.75%.  In response to the rate increase, long term interest rates (30 year bond rate) actually fell.  Explain why.

3.  (10) Discuss the advantages and disadvantages of a dollar-based monetary policy for a country like Argentina, which formerly was a high inflation country.

T-F-Uncertain, Explain in a short essay of at least one full paragraph.
4. (10) A carefully diversified portfolio with 50 or more stocks in many different industries eliminates risk.

PROBLEMS
1. (10) Assume that over the last five years, M1 has grown from \$1082B to \$1448B.  Real output (Real GDP) has grown from \$8200B to \$9740B during this period.
a. Calculate the compounded growth rate of M1 and the compounded growth rate of real output over this period.
b. Using the quantity theory of money (MV = PY) and assuming that Velocity is constant, predict the rate of inflation over this period. Explain your answer in words, specifically addressing what caused inflation.
c. Use the information above. Under a fixed growth rate rule for monetary policy, what should the approximate money growth rate be?  Explain your answer.

2. (10) Over a 6 year period, nominal GDP has gone from \$5200B to \$8252B while CPI has gone from 145 to 188.  a. Calculate the nominal, compounded growth rate of nominal GDP and inflation rate over this period.
b. Calculate the growth rate in real output during this period.
c. Explain you answer in words, addressing the difference between nominal and real GDP growth.

3. (20) You are given the following information on bonds.

Type             Coupon Rate             FV                Term              Price
Zero Coupon                -               \$1000             10 years          \$500
Regular T-bond          8.5%           \$1000             5 years            \$950
Index T-bond             4%              \$1050             5 years            \$975
Muni-bond                 5%              \$1000             5 years            \$925

a. calculate the yield to maturity (YTM) for each bond. (2 points each)
b. using the information above,    what is the expected rate of inflation over the next five years? Explain your answer in words.  (3 points)
c. Using our answer from part b, if  actual inflation rate over the next five years is 6% per year, would a person who bought the Regular T-bond benefit?  Why or why not?  (3 points)
d. assuming that Regular T-bonds are fully taxable, would a person in the 35% tax bracket prefer the muni bond (tax-free) or the Regular T-bond? Explain your answer  (Assume that there is no difference in risk) (3 points)
e. Explain in a short essay why the Regular T-bond above is selling at a discount.  (3 points)