Name : ______

Midterm 2 – November 2, 2012

In this midterm all interest rates are annualized yields. Namely if the interest rate is x then the return over t years is

  1. The following questions are regarding the Federal Deposit Insurance Corporation (FDIC).
  2. (2 points) What act of congress created the FDIC?
  1. (4 points) One of the primary reasons that the FDIC was created was to prevent bank runs. Give two reasons why it might not be sufficient by itself to prevent bank runs.
  1. The following question deals with the exchange rate : 1.3450 USD/EUR.
  2. (2 points) If the Euro weakens by 1% versus the dollar what is the new exchange rate?
  1. (2 points) In the long run would you expect the US dollar to strengthen or weaken versus the euro if inflation expectations were to increase in the US as compared to the European Union? Why?
  1. (2 points) In the long run would you expect increased import duties on US cars into the European Union to strengthen or weaken the US dollar versus the Euro? Why?
  1. The following problems have to do with the efficient markets hypothesis.
  2. (4 points) Define the efficient markets hypothesis.
  1. (4 points) Give two pieces of evidence in support of the efficient markets hypothesis.
  1. (4 points) Give two pieces of evidence against the efficient markets hypothesis.
  1. Assume that the reserve requirements by the Federal Reserve are 10% of all checkable deposits. In the following problems there are two people with currency: Fred has $1,000 in his pocket and Sue has $500 dollars in her pocket. Further assume that there are two banks in existence with the following assets and liabilities:

Bank 1

Assets / Liabilities
Reserves / $500 / Fred’s checking account / $5,000
Loan to Sue / $2,500
Vault Cash / $2,000

Bank 2

Assets / Liabilities
Reserves / $4,000 / Sue’s checking account / $10,000
Loan to Fred / $2,500
Vault Cash / $3,500

Finally the Federal Reserve has issued only the cash that is held by Fred, Sue and the two banks. The Federal Reserve also has assets of $11,500 of T-bills.

  1. (4 points) Draw an assets and liabilities table of the Fed Reserve.
  1. (4 points) What are the components of the Monetary Base? Find the current value of the Monetary Base.
  1. (4 points) What are the components of M1? Find the current value of M1.
  1. The following question refers to interest rates that are relevant to the Federal Reserve. Normal market conditions refer to the conditions that are normally prevalent in the market – the discussion in your textbook assumes normal market conditions.
  2. (4 points) What is the relationship (as in less than, greater than, equal etc.) between the primary credit rate (the discount rate) and the Fed Funds rate? Why would you expect this relationship to be true?
  1. (4 points) What is the relationship between the primary credit rate (the discount rate) and the rate that the Federal Reserve pays on reserves? Why would you expect this relationship to be true?
  1. (2 points) In normal market conditions what is the relationship between the Fed Funds rate and the rate that the Federal Reserve pays on reserves? Why do you expect this relationship to be true?
  1. (2 points) What is the current relationship between the Fed Funds rate and the rate that the Federal Reserve pays on reserves?
  1. Assume that a market is fair and is displaying the following rates for South African Rand (ZAR) and Norwegian Krona (NOK).

7.7-7.8ZAR/USD

5.7-5.8NOK/USD

  1. (4 points) correctly fill out the following table

Market / Market Buys ______and sells USD / Market Sells ______and buys USD / Units
ZAR / ZAR/USD
NOK / NOK/USD
  1. (4 points) Correctly fill out the following table

Market A / Market Buys ZAR and sells NOK / Market Sells ZAR and buys NOK / Units
ZAR / NOK/ZAR
  1. (4 points) You find another market participant who is willing to exchange NOK and ZAR as follows. Is there an arbitrage available in the market? How do you take advantage of it? Be specific.

Market B / Market Buys ZAR and sells NOK / Market Sells ZAR and buys NOK / Units
ZAR / 0.70 / 0.72 / NOK/ZAR
  1. The following questions deal with the subject of central bank independence.
  2. (2 points) Define goal independence.
  1. (2 points) Define instrument independence.
  1. (2 points) Which of the following central banks has the least goal independence: the European Central Bank, the Bank of England or the Federal Reserve? Why?
  1. (4 points) Give two reasons for having a more independent central bank.
  1. (4 points) Give two reasons against having a more independent central bank.
  1. The Federal Reserve uses open market operations to help target the Fed Funds rate.
  2. (4 points) Draw a supply and demand curves showing the relationship between reserves, the fed funds rate, the primary discount rate and the interest rate that the Federal Reserve pays on reserves. Label your axes.
  1. (4 points) Demonstrate using the supply and demand curves the impact of an open market operation in which the Federal Reserve sells 10-year Treasury Bonds.
  1. (2 points) What would you expect the effect of this operation on the Fed Funds rate to be? Why?
  1. (2 points) What would you expect the effect of this operation to be on the yield of the 10-year Treasury bond? Why?

1