To receive maximum credit:
a. Write essays of at least one full page for the essay questions and the T-F-U/Explain question.  Write essays using complete sentences.
b. Show all work to support your answers to the problems.
c. Label all numbers, graphs and diagrams with appropriate units.

Essay Questions and T-F-U/Explain

1.  (15 points) Assume that you are a U.S. hog farmer and you want to retire in 2001.  In one year you will sell off your hogs, hopefully raising somewhere around $1m from the sale.  Then you will invest half of your proceeds in U.S. T-Bonds and buy a condominium in Southern France with the other half of your proceeds.  You are extremely risk averse.  How could you use futures contracts to hedge the three risks that you are exposed to?  Be specific - explain the three specific futures contracts you would use, the position you would take on each contract, and why.   Draw a payoff diagram for your position on each contract.

2.  (20 points) What is meant by "central bank independence" and “political business cycle?”  Why is independence of the central bank important for price level stability?  Is there any empirical evidence linking central bank independence and low inflation or evidence of political business cycles?  What features of the Federal Reserve Bank contribute to its independence?

3.  (15 points) T-F-Uncertain/Explain in an essay:  If the Federal Reserve lowers reserve requirements next year, and at the same time there is an increase in drug trafficking, the money supply will increase.

Problems  (points in parentheses)

1. (15 Points Total) December 2001 crude oil futures contracts are currently trading at about $25/bbl.  Assume that you have reliable inside information not yet available to the public that the Bush administration will soon allow oil drilling in currently protected oil-rich areas of Alaska, creating a significant increase in the supply of crude oil.
a. Explain how you would use this information to speculate in the futures market, and show a payoff diagram of your position and your potential profits and losses.
b. If the actual spot rate for oil in December turns out to be $24.50 (2% below $25), and you have one contract for 1000 barrels, did you make or lose money?  How much?
c. If the actual spot rate for oil in December turns out to be $25.75 (3% above $25), and you have one contract, did you make or lose money?  How much?
d. If you total initial investment was 4% of the total contract value and you have one contract for 1000 barrels, calculate your rate of return on your investment in oil futures in parts b and c.  (Rate of return (%)  = [$Profits (Losses) / $Initial Investment] x 100.)
e. Futures markets are considered to be extremely risky because they are highly leveraged.  Use this problem as an example and explain this.
 

2. (30 Points Total) You are given the following information: (all dollars are in Billions)

Monetary Base (MB) = $625B
Currency (C) = $500B
Currency / Deposit Ratio ( C / D ) = .50

a. calculate bank deposits (D), the money supply (M1), reserves (R), required reserve ratio (r_D), loans & securities, simple deposit multiplier (SDM), the deposit multiplier (DM) and the money multiplier (m).
b. for a $40B expansionary Open Market Operation (OMO), what is the absolute MINIMUM change in the Money Supply (M1), and under what extreme conditions would that occur? (Hint: the person who sells the T-bill to the Fed cashes the check for currency, NO money stays in the banking system).
c. for a $40B OMO, what is the absolute MAXIMUM change in M1, and under what extreme conditions would that happen?  (Hint: NO currency leaks out of the banking system, all new money stays in banks )
d. show the anticipated actual effects of a $40B expansionary OMO on the changes in M1, D, C, R, Loans, and MB.
e. show a fully labeled funnel diagram of the OMO, with the changes in the variables from part d.
f. what is the percentage change in M1 from the OMO?
g. Before the OMO, the $/£ ex-rate was $1.60.  Assuming that the supply of British pounds remains unchanged and that the change in the supply of dollars is fully reflected in a change in the exchange rate value of the dollar, predict the ex-rate (to four decimal places) after the OMO?
Use the original monetary values (before the $40 OMO) for the following questions:

h. If the Fed wants to decrease the money supply by 4%, what size and type of OMO should it implement?

i. Assuming that the original amount for the MB stays the same, what would happen to the money supply in percentage terms if the reserve requirement was changed to 10% (r_D = .10)?  (Hint: Calculate the new money multiplier, then using the MB, calculate the new amount of M1 and then calculate the percentage change).

j. Assuming the original MB and the original r_D, what would happen to the money supply in percentage terms if an increase in drug trafficking raised the C/D ratio to .75?  (Follow the procedure outlined for problem i above).