Problem 01.

Explain your answer

1. The following is from an article in the Wall Street Journal, describing events in the market for Treasury securities on the given day: "Treasury prices were mixed, with the shorter end of the yield curve falling and the longer- dated Treasury rising in prices".

Draw Treasury yield curve, showing the situation on that day as described in the sentence above.

Explain why prices of Treasury were mixed with the shorter end of the yield curve rising in prices and the longer- dated Treasury falling in prices.

2. Over the years, income tax rates have changed dramatically. In 1981, the highest tax rate was reduced from 70 percent to less than 40 percent. What impact do you think this reduction had on the difference between yields on U.S Treasury bonds and municipal bonds?

During the last recession if 2007-2009 income taxes stayed the same, however municipal bonds paid higher interest rate than U.S Treasury and at the end of the recession the same interest rates as U.S. Treasury? How would you explain it?

3. A bank has issued a one year certificate of deposit for $50 million at an interest rate of 3 percent. With this proceeds, the bank has purchased a two-year Treasury note that pays 4 percent interest. What risk does the bank face in entering into these transactions? What would happen if all interest rates rose by 1 percent? Explain

4. In 1960, federal regulations prohibited banks from paying interest rate on checking accounts. Today, banks are legally allowed to pay interest rate on checking accounts, yet the value of checking accounts has shrunk from more than 50% of commercial banks liabilities in 1960 to less than 12% .Because checking accounts now pay interest rate, should not they become more popular with household rather than less popular? Explain your answer

5. "A bank that expects interest rates to decrease in the future will want the duration of its assets to be greater than the duration of its liabilities" Explain if you agree with this statement and why

6. "Whenever currency is deposited into a commercial bank, cash goes out of circulation and, as a result, the supply of money is reduced". Do you agree? Explain why or why not.

7. The Happy Bank receives an extra $1,000 of reserves but decides not to lend any of these reserves out. How much deposit creation takes place for the entire banking system? Explain your answer.

8. Milton Friedman believed that the Fed should control the money precisely. In the 1960s, he proposed that the required reserve ratio be raised to 100 percent. How would this policy improve the Fed control of the money supply? What are the drawbacks to the policy? Explain

9. The natural rate of unemployment varies over time, with changes in demographics, the structure of the economy and government policies. For its goal of low unemployment, why would if be crucial for the Federal Reserve to be aware of the variations in the natural rate of unemployment? Explain

10. Achieving a goal of price stability with low and steady inflation allows the Fed to achieve other goals, such as interest rates stability and stable foreign exchange rate. If the Fed fails to achieve low and steady inflation, why will be hard to achieve stable interest rates? Explain

11. Which type of unemployment, frictional, structural or cyclical, does the Fed seek to reduce? Why does not the Fed seek to reduce the unemployment rate to zero?

12. During the Great depression the excess reserves to deposits ratio rose dramatically. What do you think happened to the money supply? Why?

13. In Fall 1999, people in the financial community were making their final plans for the beginning of the year 2000. Everyone was concerned about the Y2K problem. The primary concern was that public would panic and remove significant amount of cash from banks.

What would be the effect of removing cash from banks on the following: the monetary base, the money multiplier and the money supply?

Explain the banking system response to the expected event

Explain the fed response to the expected event

14. The public cash withdrawals from banks decrease the central bank liabilities and shrink the size of the banking system balance sheet. Do you agree or not? Explain your answer. Use the Fed and the banking balance sheet to support your answer.

15. The U.S. Treasury maintains accounts at commercial banks. What would be the consequences if the Treasury shifted funds form those banks to the Fed? What would be the appropriate response by the Fed to keep the moneys supply at the desirable level?

16. How does the existence of the lender of last resort create moral hazard? Explain

17. As part of the response to the financial crisis of 2007 and 2009 the Fed purchased very large quantities of government bonds. Explain how the Federal Reserve's action in response to the financial crisis of 2007-2009 affected:

a. The Fed balance sheet,

b. The monetary base,

c. The level of reserves in the banking system

d. The money multiplier,

e. The money supply

f. The expectations about future inflation?

18. Given the following information and using the Taylor rule, calculate the target for the federal funds rate for October 2012

Equilibrium real federal funds rate of 2%

Target inflation rate of 2%

Current inflation rate of 1.2%

Output gap negative 5.9%

a. Calculate the target for the federal funds rate for October 2012

b. Explain how the targeted federal funds rate calculated using the Taylor rule compare to the actual federal funds rate of 0% to 0.25%.

c. Explain the deviation in the actual federal funds rate from the targeted federal funds rate calculated using the Taylorrule

19. The following statement appeared in the New York Times that provides an overview of the Federal Reserve System: 'The federal funds rate is set by the Fed's FOMC, composed of the chairmen, the six governors and five of the 12 districts banks presidents". Do you agree that the federal funds rate is set by FOMC? Briefly explain

20. The Fed started to pay interest on reserves, following the example of central banks in a number of other countries. What impact such a change has on excess reserves holdings and the money multiplier? Explain

21. The Fed continued to pursue unusual policy measures for several years after the end of the financial crisis of 2007- 2009. Chairman Bernanke and other members of the FOMC continued to discuss an "exit strategy" to shrink its balance sheet and return bank reserves and the monetary base to more normal levels.

What would be the effect of lending by the banks the large amounts of excess reserve?

How could the Fed use the interest rate on reserves to restrain banks form lending the large amounts of excess reserve and increase the money supply excessively?

Discuss at least two ways the Fed can use to restrain banks from lending

22. To hit the target federal funds rate given in the FOMC's policy directive,

Does the manager of the Trading Desk adjust demand for reserves, the supply of reserves, or both?

What monetary policy tool does the manager of the Trading Desk use to hit the target federal funds rate?

On most days, does the Trading Desk carry out open dynamic open market operations or defensive open market operations?

Problem 02.

Assume a monopolistically competitive car industry.

The demand facing any given producer is given by

Qi = S [(1/N) - (1/30,000)(Pi - PA)]

where Q is the firm's sales

S is the total sales of the industry (size of the market)

N is the number of firms in the industry

Pi is the price charged by the firm itself

PA is the average price charged by the firm 's competitors

The total cost function for producing cars is

C= 750,000,000 + 5000Q

Now, suppose that there are two countries: Home and Foreign. Home has annual sales of 900,000 cars and Foreign has annual sales of 1.6 million. The two countries have the same cost of production.

Derive the PP and CC relationships for Home and determine the equilibrium price and number of firms.(10)

Derive the PP and CC relationships for Foreign and determine the equilibrium price and number of firms.(10)

Now assume no transportation cost and that it is possible for Home and Foreign to trade cars with one another. Derive the PP and CC relationships for this integrated market and determine the equilibrium price and number of firms.(10)

Suppose that the two countries were to integrate their car market with a third country with an annual market for 3.75 million cars. Find the number of firms, the output per firm and the price per car in the new integrated market after trade.

Section B.

Solve the following questions.

Question 1: Louis the retired Canadian lives on a fixed budget and consumes only two goods: toques (T) and maple syrup (M). Suppose Louis' monthly budget is 100 and the price of the two goods are (PT, PM) = (4,2). (a) Make a properly labeled diagram illustrating Louis' budget constraint with T on the hori- zontal axis and M on the vertical axis. Indicate the area corresponding to the set of bundles (M, T) that Louis can afford (b) What is the maximum T that Louis can afford? What about the maximum M? (c) What is the slope of the budget line, and what is the economic interpretation of it? (d) Suppose the Canadian government decides to ration maple syrup, limiting each person to a maximum of 40 units of maple syrup per month. Draw a new diagram showing Louis' new budget constraint and indicate the area corresponding to the set of bundles that Louis can afford now. Question 2: Annie and Marty are both single parents with full-time jobs. Consequently, both value child care services (5) and children's clothing (C) but may have different preferences for the two goods. The government decides it wants to make life easier for single parents and is considering providing single parents with monthly child care vouchers or, simply, providing single parents with a cash payment every month. Suppose Annie and Marty's incomes are both 400, the price per unit of child care is 10 per unit and the price per unit of clothing is 20. (a) Draw Annie's budget constraint assuming the government decides to offer a $100 voucher for child care. (b) Draw Marty's budget constraint assuming the government decides to offer a $100 cash payment to single parents. (c) Draw an indifference curve representing Annie's preferences that is consistent with Annie strictly preferring the cash payment to the voucher. (d) Draw an indifference curve representing Marty's preferences that is consistent with Marty being indifferent between the cash payment and the voucher. Question 3: After winning the lottery, Australian Artie decides to retire, stay home, and watch sports on television all day. Artie likes both Rugby, R, and Aussie Rules Football, F and views them as imperfect substitutes. In particular, Artie's preferences can be represented by the follow- ing utility function: U = R04Foe. Since Artie is rich, the only cost of watching F is the opportunity cost of not watching R: one hour of R necessarily means one hour less of F. In other words, even though Artie is rich, there is still a price on his time. 1-2 of 2(a) What is Artie's marginal rate of substitution between R and F, MRSay? Interpret it. (b) What is the price ratio, PR/PF? Interpret it. (c) Suppose Artie chooses some bundle, (R, F). If this bundle maximizes Artie's utility, what relationship must hold between R and F? (d) Define ME. What is the interpretation of this? If Artie is maximizing his utility, what must FR MUs be equal to? (e) Suppose there are 24 hours in a day. What bundle (R, F) will Artie consume? [Now you should find actual numbers.] Question 4: Picky Pete drags Indifferent lan out for coffee at an upscale Italian cafe which sells only espresso (E) and biscotti (B). Picky Pete simply must have one biscotti for every espresso consumed, whereas Indifferent lan views espresso and biscotti as perfect substitutes. One of their utility functions is given by U = min [E, B] and the other's by U = E + B. (a) Given the description, which utility function corresponds to which person? (b) Suppose the prices of the goods are (PEPs) = (2,1) and Pete has allocated $12 for the outing while lan brought only $4. Solve for each person's utility-maximizing bundle of espresso and biscotti. (c) Draw a fully labeled diagram illustrating Pete's budget constraint, his optimal bundle, and an indifference curve representative of his utility at his optimal bundle. Indicate how much utility Pete obtains. (d) Do the same for Ian. Question 5: Energetic Erin consumes a worrisome amount of caffeinated beverages, particularly soda (S) and coffee (C). A utility function representing her preferences is given by U = 450503. Erin's Income is 120 and the prices of the two drinks are given by (ps. pc) = (4,2). (a) Solve for Erin's utility maximizing bundle of beverages and calculate how much utility she obtains from it. (b) Suppose Erin moves to Berkeley where there is a soda tax and, consequently, the price of soda is 6. Solve for Erin's new utility maximizing bundle of beverages and calculate how much utility she obtains now. What is the "total effect" of the price change on Erin's consumption of soda? (c) Draw a diagram showing Erin's budget constraint before and after the move, and repre- sentative indifference curves of her choices before and after the move. (d) The total effect you found in part "b" can be broken down into a "substitution effect" and an "income effect". What is the sign of: (i) the total effect, (ii) the substitution effect, and (iii) the income effect? Explain why for (ii) and (uil). 1-2 of 2