Suppose the yield to maturity on a 2 year Treasury note was 4 %

Suppose the yield to maturity on a 2 year Treasury note was 4 %

Suppose the yield to maturity on a 2 year Treasury note was 4 %

1) Suppose the yield
to maturity on a 2 year Treasury note was 4 % while the yield on a 1 year note
was 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?
2pts
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) 4pts

2) Suppose the CFO
of an American corporation with surplus cash flow has $90 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 .5 %, while the rate on 1 year CD
deposits (denominated in Australian dollars) is currently 2.5 %. Suppose
further that the exchange rate currently is (.8) Australian Dollars per US $.
What must the CFO expect
about the Australian Dollar/US$ exchange rate 1 year from now if she chooses to
invest in the US $ CD’s instead of the Australian CD’s? (Note: a specific
numeric answer is required for full credit. Part credit can be earned for
correctly identifying and discussing the issue here without a specific numeric
answer.) 4pts.

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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.
A) Explain why the
Fed created all these extraordinary direct lending facilities, instead of
simply relying on traditional open market purchases of Treasury securities.
(hint: You may wish to look at Bernanke’s recent lecture series at GW
university (on the Federal Reserve Website)—particularly the 3rdin the 4 lecture series. A link to it is on the main Federal Reserve
site page) 4 pts
B) As conditions in short term financial markets
improved by summer of 2009 the Fed closed down its lending under almost all
these programs. However, since then the Fed has engaged in 3 campaigns in which
for a period of months it has increased substantially its purchases of longer
term mortgage backed securities and treasury notes from banks. These programs
were called “Quantitative Easing 1, 2 and 3. QE 3 has just begun this Fall and
according to the Fed will be maintained until real economic growth strengthens
and the unemployment rate declines.
What is the effect
of these QE programs on banks’ balance sheets? Explain briefly 4pts.
C) What would
believers in the quantity theory of money (monetarists) expect to result from
these large scale purchases of securities by the Fed? Explain your answer in a
few sentences and discuss the concept of the velocity of circulation in your
answer. 4 pts
D) Assume that at
some point in the next year or two both lender & borrower confidence levels
start to return to normal and financial and physical investment levels start to
rise much more strongly than in the last 2 years.
What potential
problem will the balance sheet effects of Quantitative Easing described in your
answer to part B create then for the Fed? 2pts
How will the Fed’s
relatively recent authorization to pay interest to banks on their reserve
accounts at the Fed help the Fed deal with this problem? Explain. 2pts.

4) At the same
meeting of the open market committee where it announced Quantitative Easing 3,
the Fed chose to also announce that its currently low Fed funds rate of 0 to
.25% would be maintained until at least the middle of 2015. Previously it had
merely said that it would keep that rate low until early 2014. Why would
changing investors’ expectations that the Fed would keep the overnight Fed
Funds rate at its current low level for at least 18 months longer than
previously promised be helpful to the Fed at this time. (hint…think about shape
of the Treasury yield curve)
Explain your answer
in a paragraph.
4pts

5) 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. 4pts
6) Signs of investor uneasiness in continuing to
purchase treasury securities issued by heavily indebted sovereign states such
as Greece and Spain have triggered a debate about raising the debt ceiling
here. “Tea Party” republicans in the House of Representatives have made “out of
control” government spending a rallying cry in all their political campaigns
since fall 2010 and insist that any legislation to balance the federal budget
over the next few years must rely solely on reductions in government spending
and transfer programs with no tax increases. The republican presidential
candidate in the current election repeats this party line as well. Democrats
insist that some significant portion of any deficit reduction package must be
based on closing tax loopholes and increasing marginal tax rates on wealthy
households (income greater than $1 million). They also argue that although
credible deficit reduction measures need to be put in place soon, the actual
phase-in of those measures—whether tax increases or reductions in entitlement
spending programs –must be gradual and await a strengthening of RGDP growth in
the US economy.
Given the current
situation of the US economy, compare and contrast the views of a “Keynesian”,
to those of a “Supply Sider” with respect to the issues in this debate.
(Note:
you do not have to agree with my political perspective to score well on this
question. You do need to demonstrate understanding of the arguments on either
side of the debate between Keynesians and Supply Siders and demonstrate
understanding of the distinction between the short run and the long run in
terms of those issues. 6pts

 

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