FIN 301/ECON 210-10
Money and Banking
SAMPLE FOURTH QUIZ
Answer all the questions. Include calculations and/or reasons with your answers wherever appropriate. More credit will be given for correct reasoning than for correct numbers.
1. Congress changes the Humphrey-Hawkins Act, so that not only will the Chairman of the Fed have to come to the senate and talk about inflation and unemployment twice each year but must now take action. Whenever the rate of unemployment rises past 7% the Fed must speed up the growth of the money supply enough to produce a rate of inflation 3 percentage points higher than it has been for the last six months and maintain that rate for two years.
(a) If people form their expectations adaptively, what will happen as a result of this change in policy?
(b) If people form their expectations rationally, what will happen as a result of this change in policy?
2. As the gavel is about to come down on an interest rate of 10% for the last time a Crusoe arrives with news. The Crusoes restart the auction. After this news will the new interest rate be higher or lower than 10%? Explain.
(a) Half the wheat in storage is rotten and cannot be used.
(b) Trees shading some of the plots have fallen raising the amount of sunlight on those plots and therefore raising their rates of return.
3. Congress reinstitutes the investment tax credit. Now each company investing in “qualified” plant, equipment, or research, can reduce its tax bill by 6% of the price immediately without affecting the cash flows from the investment. What will happen to interest rates? Explain.
4. The Fed has now lowered the target federal funds rate again to 0.5%. To keep the rate low what does it do? If the Fed continues this over time and banks do not like excess reserves because the Fed does not pay interest on them, what will happen to interest rates? How long will all this take if the Fed announces its intention ahead of time? What is different now that the Fed does pay interest on reserves?
5. What is a Lender of Last Resort? What should it do, and what should it not do when there is a financial crisis? What happened between 1929 and 1933 when the Fed did not fulfill this role?
6. True, False, or Uncertain? Explain and/or correct the saying.
“Inflation is good for borrowers and bad for lenders.”
7. What factors that we now understand produced the Sub-prime Mortgage Meltdown and the financial crisis of 2008? (I will have to cut this question into more manageable pieces.)