b) rises; falls c) falls; rises d) falls; falls Answer: D
Question Status: Previous Edition
Part Ⅱ. This part has 10 True of False Questions and each one is worth 1 points. The total points
for this part are 10 points.
1 In a world without information and transaction costs, financial intermediaries would not exist. Answer: True
2 If reserve requirement were elimininated, it would be harder to control interest rates. Answer: False
3 The quantity demanded of an asset is positively related to its liquidity relative to alternative
assets.
Answer: True
4 The price-level effect from an increase in the money supply is a decrease in interest rates in response to the rise in the price level. Answer: False
5 The yield to maturity is greater than the coupon rate when the bond price is below its face value.
Answer: True
6 Foreign exchange rates, like stock prices, should follow a random walk. Answer: True
7 Given the return on assets, the lower the bank capital, the higher the return for the owners of the bank. Answer:True
8 The goal for high employment should therefore not seek an unemployment level of zero. Answer: True
9 Banks are not the most important source of external funds used to finance businesses. Answer: False
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10 If bonds of different maturities are close substitutes, their interest rates are more likely to move together. Answer: True
Part Ⅲ. This part has 4 Key Terms Questions and each one is worth 2.5 points. The total points for
this part are 10 points. Please explain briefly for each key term. 1 Default-free bonds P.121 2 Monetary base P.358
3 Open market operations P.359
4 Risk structure of interest rates P.120
Part Ⅳ. This part has 5 Essay Questions and each one is worth 12 points. The total points for this
part are 60 points. ( Please write down your answers as clearly as possible. If I can’t read your hand-writing, I never assume your answers are right )
1 Explain two reasons why the Fed does not have complete control over the level of bank deposits and
lows. Explain how a change in either factor affects the deposit expansion process.
Answer: The Fed does not completely control the level of bank deposits and loans because banks
can hold excess reserves and the public can change its currency holdings. A change in either factor changes the deposit expansion process. An increase in either excess reserves or currency reduces the amount by which deposits and loans are increased.
2 Demonstrate graphically and explain how a reduction in default risk affects the demand or supply of
corporate and Treasury bonds. Answer:
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A reduction of default risk increases the demand for corporate bonds and reduces the demand for Treasury bonds. Corporate bond prices rise and interest rates fall. Treasury bond prices fall and interest rates rise. In the graph, the price of corporate bonds after the decrease in default risk must still be above the new Treasury bond price, since corporate bonds are not free of default risk.
3 Explain the Fed’s three tools of monetary policy and how each is used to change the money supply.
Does each tool affect the monetary base or the money multiplier?
Answer: The three tools are open market operations, the purchase and sale of government securities;
discount policy, controlling the price of discount loans to banks; and reserve requirements, setting the percentage of deposits that banks must hold in reserve. Open market operations and the discount rate affect the monetary base, and reserve requirements affect the money multiplier.
4 Explain the concepts of asymmetric information, adverse selection, and moral hazard. When do
adverse selection and moral hazard become relevant to the lending process? How has the financial system developed to deal with these problems?
Answer: Asymmetric information is uneven information, which creates the problems of adverse
selection and moral hazard. Adverse selection is having a disproportionate number of high-risk loan applications. Moral hazard is the risk that the borrower will engage in risky behavior after the loan is made. Adverse selection is a problem before a loan is made, and moral hazard is a problem that exists after a loan is made. Financial intermediaries develop the expertise to screen and monitor loans, overcoming these problems. Regulations require timely provision of information.
5 Why has the development of overnight loan markets made it more likely that banks will hold fewer excess reserves?
Answer: Because when a deposit outflow occurs, a bank is able to borrow reserves in these overnight loan
markets quickly; thus, it does not need to acquire reserves at a high cost by calling in or selling off loans. The presence of overnight loan markets thus reduces the costs associated with deposit outflows, so banks will hold fewer excess reserves.
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