As conditions in short term financial markets improved by summer of 2009 the Fedclosed down its lending under these programs. However, throughout the next 4 years theFed increased substantially its purchases of longer term mortgage backed securities andTreasury notes from banks in a series of 3 “Quantitative Easing” (QE) Programs.

ECO201Pricniples of Macroeconomics Final Examination

1) Here’s a quote from Fed head Janet Yellen on at a meeting in Cleveland on July10 this year. (see www.federalreserve.gov then click news and events…Regarding inflation, as I mentioned earlier, the recent effects of lower prices for crude oil andfor imports on overall inflation are expected to wane during this year. Combined with furthertightening in labor and product markets, I expect inflation will move toward the FOMC’s 2percent objective over the next few years. Importantly, a number of different surveys indicatethat longer-term inflation expectations have remained stable even as recent readings oninflation have fallen. If inflation expectations had not remained stable, I would be moreconcerned because consumer and business expectations about inflation can become selffulfilling.

Explain why the FOMC is concerned not only about actual recent inflation ratesas measured by the CPI, but also about longer term inflation expectationsremaining “stable” In particular, what is the problem if inflation expectationsstart to converge to an opinion that inflation will fall to “0” or less? 4pts

2) Suppose the CFO of an American corporation with surplus cash flow had $100million to invest last July 15 and the corporation did not believe it would need toutilize these funds to retool or expand production capacity for 1 year. Suppose furtherthat the interest rate on 1 year CD deposits in US banks was .5%, while the rate on 1year CD deposits in England (denominated in British Pounds) was 2% at the time.Suppose further that the exchange rate at that time was $1.68 per British pound .

A) Suppose that now a year later the exchange rate is $1.55 per US pound. What rateof return did the CFO earn on the investment in the British CD? (Note: a specificnumeric answer is required for full credit.) 4pts.

B) What must the CFO have expected about the value of the British pound in $ todayto believe that investment in British CD’s was more profitable than investment in USCD’s last July? 2pts

3) Between February 2008 and Summer 2009, the Fed supplemented its open marketoperations with a greatly expanded program of direct lending (both overnight and shortterm 28 and 84 day loans) to commercial banks, investment banks, brokerage andprimary dealer units of bank holding companies. It also agreed to accept a wider range ofshort term securities (instead of accepting only T-Bills) as collateral on these loans andeven initiated a program to buy commercial paper from money market funds.Explain why the Fed created all these extraordinary direct lending facilities instead ofsimply relying on traditional open market purchases of Treasury securities.4 pts

4) As conditions in short term financial markets improved by summer of 2009 the Fedclosed down its lending under these programs. However, throughout the next 4 years theFed increased substantially its purchases of longer term mortgage backed securities andTreasury notes from banks in a series of 3 “Quantitative Easing” (QE) Programs.

A) Assume that both lender & borrower confidence levels start to return to normal andfinancial and physical investment levels start to rise much more strongly in the next 12months than in the last few years. What potential problems will the extraordinary growthin banks’ reserve deposits and in the size of the Fed’s portfolio of longer term Treasuryand Mortgage backed bonds that has resulted from 3 rounds of Quantitative Easing createthen for the Fed? 4pts

B) What relatively untested policy tools will help the Fed deal with this problem?Explain. ( Hint: you may wish to look at www.federalreserve.gov then click monetarypolicy…then Policy Normalization: principles and Plans) 4pts.

5) In recent weeks markets around the world have been rattled by signs of a slowdown ingrowth of the Chinese economy, together with a massive sell–off in its stock market…plus a massive default by Greece on its debts to the IMF , the ECB and on its government bonds which will be averted only if it agrees to harsh budget austerity measures imposedby Germany and the rest of the European Union…In the process, the value of the $ hasrisen against the Euro, the Yuan and many other currencies

A) Given the current condition of the US economy, do you think US policy makerswould 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 astronger vs. a weaker $. Frame your answer in terms of the current AggregateDemand and Aggregate Supply situation of the US economy. 4pts

B) Draw an AS/AD diagram to illustrate your answer. Clearly label axes and thecurrent position of AS, & AD relative to full employment RGDP….also indicateany shifts that would occur if the exchange rate of the $ rose sharply against othermajor currencies 2pts.

6) Current annualized yields on 1 year US treasury securities are only .28%….whilecurrent annualized yields on 2year US treasury securities are .69% (note you may assumethat both 1 and 2year securities in this example are “0” coupon securities with nopayment other than the maturity value on the maturity date.What does this data suggest about financial market expectations of 1 year yields, 1 yearfrom now? Explain…. (Assume investors are risk neutral in these short time horizonswith default free treasuries.) 4pts.

7) Each year since winning control of the House of Representatives in the 2010 election,Tea Party Republicans have argued that we need to immediately initiate sharp reductionsin government spending and entitlement programs and rapidly move towards a balancedbudget, (although they have never actually produced a budget proposal in which taxrevenues would match government spending plus entitlement transfers). ManyDemocrats, while arguing that tax rate increases on high income earners need to be partof the any deficit reduction program, have agreed that we need to initiate budget deficitreduction now.

A) What is the argument against attempting to balance the Federal Government budgetrapidly at the present time via either deep cuts in Federal Government spending or sharpincreases in federal income tax rates? 4pts

B) Does this argument imply that budget deficits don’t matter in the long run? If not, whymight the impact of large deficits predicted in the long run under current tax andspending programs be different than the impact today? Explain. 4pts.