REVISION QUESTIONS

COURSE: MONETARY AND FINANCIAL THEORIES

1. Explain the main difference between a bond and a common stock.

2. If you suspect that a company will go bankrupt next year, which would you instead hold,
bonds issued by the company or equities issued by the company? Why?
3. How does risk-sharing benefit both financial intermediaries and private investors?
7. How can the adverse selection problem explain why you are more likely to make a loan to
a family member than to a stranger? If you are an employer, what kinds of moral hazard
problems might you worry about about your employees?
8. In ancient Greece, why was gold a more likely candidate for use as money than wine?
9. Why would a government choose to issue a perpetuity, which requires payments forever,
instead of a terminal loan, such as a fixed-payment loan, discount bond, or coupon bond?
10. Under what conditions will a discount bond have a negative nominal interest rate? Is it
possible for a coupon bond or a perpetuity to have a negative nominal interest rate?
11. True or False: With a discount bond, the return on the bond is equal to the capital gain
rate.
12. If interest rates decline, which would you instead be holding, long-term bonds or short-
term bonds? Why? Which type of bond has the greater interest-rate risk?
13. Answer the following questions:
a. If the interest rate is 15%, what is the present value of a security that pays you $1,100 next
year, $1,250 the year after, and $1,347 the year after that?
b. Calculate the present value of a $1,300 discount bond with seven years to maturity if the
yield to maturity is 8%.
c. A lottery claims its grand prize is $15 million, payable over five years at $3,000,000 annually.
If the first payment is made immediately, what is this grand prize really worth? Use an interest
rate of 7%.
d. What is the yield to maturity on a $10,000-face-value discount bond, maturing in one year,
which sells for $9,523.81?
e. Which $10,000 bond has the higher yield to maturity, a 20-year bond selling for $8,000 with
a current yield of 20% or a 1-year bond selling for $8,000 with a current yield of 10%?
14. Consider a coupon bond with a $900 par value and a coupon rate of 6%. The bond is
currently selling for $860.15 and has two years to maturity. What is the bond’s yield to
maturity?
15. Explain why you would be more or less willing to buy gold under the following
circumstances:
a. Gold again becomes acceptable as a medium of exchange.
b. Prices in the gold market become more volatile.
c. You expect inflation to rise, and gold prices tend to move with the aggregate price level.
d. You expect interest rates to rise.
16. Raphael observes that at the current level of interest rates, there is an excess supply of
bonds, and therefore, he anticipates an increase in the price of bonds. Is Raphael correct?
17. Using the supply and demand analysis for the bond market, answer the following
questions:
a. What will happen in the bond market if the government limits the amount of daily
transactions? Which characteristic of an asset would be affected?
b. How might a sudden increase in people’s expectations of future real estate prices affect
interest rates?
c. Suppose that many big corporations decide not to issue bonds since it is now too costly to
comply with new financial market regulations. Can you describe the expected effect on
interest rates?
d. Will there be an effect on interest rates if brokerage commissions on stocks fall? Explain
your answer.
18. Using the supply and demand analysis for the bond market, answer the following
questions:
a. The president of the United States announced in a press conference that he would fight the
higher inflation rate with a new anti-inflation program. Predict what will happen to interest
rates if the public believes him.
b. Suppose you are in charge of your company's financial department, and you have to decide
whether to borrow short- or long-term. Checking the news, you realize that the government
is about to engage in a major infrastructure plan in the near future. Predict what will happen
to interest rates. Will you advise borrowing short or long-term?
19. What are the transaction costs problems facing financial organizations? Explain how
financial intermediaries can help reduce these problems.
20. Explain why dating can be considered a method to solve the adverse selection problem.
21. Why are financial intermediaries willing to engage in information collection activities when
investors in financial instruments may be unwilling to do so?
22. Would you be more willing to lend to a friend if she had put all her life savings into her
business than you would be if she had not done so? Why?
23. What steps can the government take to reduce asymmetric information problems and help
the financial system function more smoothly and efficiently?
24. Which problem of asymmetric information are prospective employers trying to solve when
they ask applicants to go through a job interview? Is that the end of the information
asymmetry?
25. Classify each of these transactions as an asset, a liability, or neither for each of the
“players” in the money supply process—the Federal Reserve, banks, and depositors.
a. You get a $10,000 loan from the bank to buy an automobile.
b. You deposit $400 into your checking account at the local bank.
c. The Fed provides an emergency loan to a bank for $1,000,000.
d. A bank borrows $500,000 in overnight loans from another bank.
e. You use your debit card to purchase a meal at a restaurant for $100.
26. Answer the following questions (using the T-accounts to illustrate):
a. If a bank depositor withdraws $1,000 of currency from an account, what happens to
reserves, checkable deposits, and the monetary base
b. If a bank sells $10 million of bonds to the Fed to pay back $10 million on the loan it owes,
what is the effect on the level of checkable deposits?
c. The Fed buys $100 million of bonds from the public and lowers the required reserve ratio.
What will happen to the money supply?
27. Describe how each of the following can affect the money supply: (a) the central bank; (b)
banks; and (c) depositors. If the Fed sells $2 million of bonds to the First National Bank, what
happens to reserves and the monetary base? Use T-accounts to explain your answer.
28. For the following operations, what happens to the central bank’s and commercial bank’s
reserves and the monetary base? Use T-account to show changes in balances. Assume that
the amount is $10 million.
a. The central bank provides loans to commercial banks.
b. The central bank sells securities to the commercial bank.
c. The commercial bank repays the loan to the central bank.
29. Using T-accounts, show what happens to checkable deposits in the banking system
a. When the Fed lends $1 million to the First National Bank.
b. When the Fed sells $2 million of bonds to the First National Bank.
30. Suppose that the required reserve ratio is 9%, the currency in circulation is $620 billion,
the amount of checkable deposits is $950 billion, and excess reserves are $15 billion.
a. Calculate the money supply, the currency deposit ratio, the excess reserve ratio, and the
money multiplier.
b. Suppose the central bank conducts an unusually large open market purchase of bonds held
by banks of $1,300 billion due to a sharp contraction in the economy. Assuming the ratios you
calculated in part (a) remain the same, predict the effect on the money supply.
c. Suppose the central bank conducts the same open market purchase as in part (b), except
that banks choose to hold all of these proceeds as excess reserves rather than loan them out,
due to fear of a financial crisis. Assuming that currency and deposits remain the same, what
happens to the amount of excess reserves, the excess reserve ratio, the money supply, and
the money multiplier?
d. Following the financial crisis in 2008, the Federal Reserve began injecting the banking
system with massive amounts of liquidity, and at the same time, very little lending occurred.
As a result, the M1 money multiplier was below 1 for most of the time from October 2008
through 2011. How does this scenario relate to your answer to part (c)?