1. Discuss the statement: “Since I have high credit card limits, I have lots of money.” Are credit cards money? Why or why not?

When you use a credit card, you are borrowing money until the end of the month or longer. Credit cards are not money. They do not meet all of the functions of money – see #3.

  1. Rank the following assets in terms of their liquidity, from least to most liquid: cash, savings deposits, gold, a house, a rare oil painting, a checkable deposit. Explain your rank order.

Rare oil painting, house, gold, savings deposits, checkable deposit, cash.

The rare oil painting is likely to have the fewest potential buyers and therefore is the least liquid. There is a larger housing market than rare oil painting market. Gold comes in different grades and would have to be analyzed before converting to cash. The value of the gold might vary from one dealer to another.

  1. What are the functions of money? Which function do you think is most important?

Medium of exchange, store of value, unit of account, standard of deferred value.

Medium of exchange is the most important.

  1. If I take $100 from my pocket and deposit it in my money market account, what happens to the Monetary Base? M1? M2?

Monetary base decreases by $100.

M1 decreases by $100.

M2 stays the same.

  1. Does the following situation involve adverse selection or moral hazard? Explain.
  2. Just before quitting my job, I take out all the credit cards I can. I plan to run them up to the limit and declare bankruptcy.

This is an adverse selection problem. Borrow knows that his actions may have adverse implications. The credit card company does not know the intentions of the borrower.

  1. The following is a quotation from a government securities dealer for a $1,000,000 note:

Rate / Maturity / Bid / Ask / Yield
6 / Aug 04 / 102:23 / 102:24 / 1.01
  1. How much is the dealer willing to pay for the note?

$1,027,188 is the bid price.

  1. What is the semiannual coupon payment? .06*1,000,000=$30,000
  1. That is the current yield? coupon/ ask price = 5.84%
  1. Suppose the price of this security falls to 100. Does its yield rise or fall? Can you give the approximate value of the new yield? (Do not calculate exactly.) The yield will rise. When a bond is selling at face value, the yield to maturity equals the coupon rate.
  1. A German government bond has an annualized yield of 7.2 percent. A U.S. Treasury bond with the same maturity has a yield of 5.6 percent. Which country’s currency is expected to depreciate? What is the expected rate of depreciation of this nation’s currency?

5.6=7.2- 1.6 . The German currency is expected to depreciate by 1.6%

  1. Suppose that a U.S. Treasury bill that has a face value of $10,000 has a discount price of $9500, and will mature in 180 days. What is its coupon equivalent yield? What is its money market yield?

Coupon equivalent yield = 500/9500*365/180 = 10.67%

Money market yield = 500/9500*360/180 = 10.53%

  1. Suppose that the three-month T-bill rate is 5.8 percent. The term premium for a six-month T-bill is equal to 0.2 percent, and the current rate on a six-month T-bill is 6.4 percent. According to the basic theory of the term structure of interest rates, what is the expected three-month T-bill rate for three months from now?

0.2 + (5.8+x)/2 = 6.4% Solve for x: x = 6.6%

  1. Give that current 6 month T-bills yield 1 percent, 10 year Treasury notes yield 3 percent and 20 year Treasury bonds yield 5 percent, draw the yield curve. Label your graph carefully. What do we mean by an inverted yield curve?

The yield curve described above is upward sloping. An inverted yield curve is downward sloping.