Reference no: EM13100937

1) Suppose the yield to maturity on a 2 year Treasury note was 4.5% while the yield on a 1 year note was 5.5%. Assume that neither Treasury note had coupon payments, so the only payment was the face value received when the note matured.

a) Why is it unusual for yields on longer term notes to be lower than yields on shorter term notes?

b) Why would any investor buy the 2 year note (instead of the 1 year) given its lower yield? (for full credit your answer must involve a specific number)

2) Suppose the CFO of an American corporation with surplus cash flow has $100 million to invest and the corporation does not believe it will need to utilize these funds to retool or expand production capacity for 1 year. Suppose further that the interest rate on 1 year CD deposits in US banks is 1 %, while the rate on 1 year CD deposits  (denominated in British Pounds) is currently 1.8 %. Suppose further that the exchange rate currently is (.6) British pounds per $. What must the CFO expect about the Pounds/$ exchange rate 1 year from now if she chooses to invest in the US $ CD's instead of the British Pound CD's? (Note: a specific numeric answer is required for full credit. Part credit can be earned for correctly discussing the expected direction of change in the exchange rate without supplying an exact answer.

3) Between February 2008 and Summer 2009 the Fed supplemented its open market operations with a greatly expanded program of direct lending (both overnight and short term 28 and 84 day loans) to commercial banks, investment banks, brokerage and primary dealer units of bank holding companies. It also agreed to accept a wider range of short term securities (instead of accepting only T-Bills) as collateral on these loans and even initiated a program to buy commercial paper from money market funds.

Explain why the Fed created all these extraordinary direct lending facilities instead of simply relying on traditional open market purchases of Treasury securities.

4) As conditions in short term financial markets improved by summer of 2009 the Fed closed down its lending under these programs. However, throughout 2009 and in the first quarter of 2010 the Fed increased substantially its purchases of longer term mortgagebacked securities and treasury notes from banks as it wound down its unusual lending loan facilities. Since then The Fed has continued to initiate unusually large "Quantitative Easing" (QE) Programs. Currently the Fed has over the last year been purchasing $85 billion per month of medium term Treasury Securities or mortgage -backed securities. Although the Fed this past summer hinted strongly that it would start to reduce the size of these monthly purchases this Fall, the recent government shutdown and threatened forced default on US treasury obligations has convinced investors that the Fed will delay any reductions in monthly Fed purchases until sometime after the New Year. Explain why the federal government shut- down and threat of default on its debt has-in all likelihood-- delayed the time at which the FED chooses to reduce its monthly purchases of government securities. A complete answer to this question will involve discussion of how QE is supposed to benefit the US Macroeconomy as well as a mention of the effects on the US Macroeconomy of the government shutdown and threatened US Treasury default.

5A) Assume that the current program of large scale purchases of Treasury securities (Quantitative Easing) mentioned in part B above is a success in the sense that both lender & borrower confidence levels start to return to normal and financial and physical investment levels start to rise much more strongly in the next year than in the last 2 years. What potential problems will the extraordinary growth in banks' reserve deposits and in the size of the Fed's portfolio of longer term Treasury and Mortgage backed bonds has resulted from Quantitative Easing create then for the Fed?

5B) What relatively new policy tool will help the Fed deal with this problem? Explain.

6) In many episodes over the last few years political unrest in the Middle East has driven up the price of oil to over $100 a barrel. Moreover, prices of many other commodities traded on world markets such as copper, cotton coffee and rice have often spiked sharply as well. Ben Bernanke, has been relatively optimistic that these commodity price increases do not threaten the US with broad based inflation. A typical Bernanke quote: "Thus, the most likely outcome is that the recent rise in commodity prices will lead to, at most, a temporary and relatively modest increase in US consumer price inflation." Meanwhile his counterpart at the ECB, Jean Claude Trichet, has been much more concerned about commodity-price driven inflation and recently signaled that the ECB might take steps to boost short term interest rates in the Euro zone despite continued weakness in RGDP growth there and concerns about sovereign debt problems in southern tier Euro zone nations.

6a) How would you expect these differences in key monetary policy makers' opinions of the inflation threat to affect the Euro/$ exchange rate? Explain your answer.

6b) Given the current condition of the US economy, do you think US policy makers would prefer to see the $ rise in value, decline in value or stay at its current value? Discuss the advantages and disadvantages to the US economy at this time of a stronger vs. a weaker$. Frame your answer in terms of the current Aggregate Demand and Aggregate Supply behavior of the US economy.

7) Signs in recent years of investor uneasiness in continuing to purchase treasury securities issued by heavily indebted sovereign states such as Greece, Ireland or Portugal have triggered a debate about extending Federal Government fiscal stimulus programs here. Republicans have made "out of control" growth in government spending a point of attack on incumbent democrat legislators and have campaigned for deep cuts in Federal spending programs since winning control of the House of Representatives in the 2010 election.

7A) What is the argument against attempting to balance the Federal Government budget rapidly at the present time via either deep cuts in Federal Government spending or sharp increases in federal income tax rates?

7B) Does this argument imply that budget deficits don't matter in the long? Explain.