Mid-term Exam 1

Mid-term Exam 1
You have 22 hours to complete this take-home exam (8am Wednesday, 2/24 – 6am Thursday, 2/25). It consists of 7 problems/free-response questions (specific points indicated with each). The exam is worth 100 points total.
Please include a full explanation for each question and include any relevant graphs necessary to support your answer, where appropriate. You may type your narrative responses directly in this document or in a separate document, if you prefer. If you draw the graphs or do any work by hand, please include a photo along with your submission when uploading to Blackboard. Do not use graphs found on the internet – any figures should be drawn by hand or created digitally on your own and must have each axis clearly labeled. You must clearly label old and new equilibrium positions. Words like show or illustrate mean that you should be drawing a graph.
Be sure to upload both the narrative responses and all graph images to Blackboard by 6am on Thursday, February 25th. No late submissions will be accepted.

1. Central banks around the world are considering the implementation of Central Bank Digital Currency (CBDC), a digital form of fiat money (i.e. money that is legally accepted and backed by the government). This would likely be a more secure digital instrument than existing cryptocurrencies, which are not backed by any government entity. Discuss the practical implications of CBDC and whether it would fulfill each of the three functions of money. (10 points)

2. Consider the implications of the liquidity preference framework for portfolio allocation. Use the market for money to show and explain how the following would affect the market equilibrium and describe the expected changes in interest rates:
a. The Fed purchases securities from banks. (5 points)

b. The economy slips into recession and household incomes fall. (5 points)

c. The Fed uses forward guidance to imply that interest rates will rise in the future. (5 points)

3. Explain how the relationship between long-term and short-term interest rates suggested by the liquidity premium theory of the term structure can explain the shape of the yield curve that we observe in the following three periods (a) – (c). Each graph is accompanied by a quote taken from the FOMC policy statement at that point in time. What must be the case in each scenario with respect to current conditions, future expectations, and anticipated policy actions? (7 points each)
a. March 2007 FOMC Statement: “Recent readings on core inflation have been somewhat elevated…In these circumstances, the Committee’s predominant policy concern remains the risk that inflation will fail to moderate as expected.”

b. December 2015 FOMC Statement: “The Committee judges that there has been considerable improvement in labor market conditions this year, and it is reasonably confident that inflation will rise, over the medium term, to its 2 percent objective.”

c. January 2020 FOMC Statement: “…economic activity has been rising at a moderate rate…overall inflation and inflation for items other than food and energy are running below 2 percent.”

4. Consider the following data from February 2018:
Current 1-year interest rate: 2%
Expected 1-year interest rates over the next four years: 2.4%, 2.6%, 2.7%

a. Determine what the Expectations Theory would suggest for the values of the 2-year and 3- bonds. (6 points)

b. If the actual 2-year rate was 2.2 and the 3-year rate was 2.4, compute the implied liquidity premium for each of these bonds. Does this align with our theory on the structure of the liquidity premium based on the preferred habitat assumptions? Why/why not? (6 points)

c. In reframing its employment mandate, the Federal Reserve has defined full employment as a “broad-based and inclusive” goal. As such, Chair Powell has stated publicly that the Fed will never declare victory on its employment goal. How might this communication strategy help control interest rates across the spectrum of terms to maturity? Use the Liquidity Premium Theory to justify your response. (6 points)

5. FOMC policymakers have also adjusted their price stability goal to define an average inflation target of 2%.
a. Given the performance of inflation in recent years in the U.S., what does this imply for the central bank’s strategy over the next 1-2 years? (4 points)

b. Suppose that the Federal Reserve successfully convinces markets that they will enact the appropriate policies to achieve this goal. Additionally, suppose the government approves another stimulus package worth more than $1 trillion. Draw and explain the effects of these factors in the bond market – describe what happens to equilibrium price and quantity, and interest rates. (10 points)

6. Recent data suggest that the Eurozone economy shrank in the fourth quarter of 2020 and is likely to continue contracting through early 2021. In light of this, the European Central Bank is pretty much determined not to change its current stimulus policies for the rest of the year. If any policy change occurs, it would be to loosen financial conditions. Draw and describe the effects of these economic conditions and policy expectations in both the government and corporate bond markets among the Eurozone countries – describe what happens to equilibrium prices and quantities, interest rates, and the risk premium. Note that you should be drawing separate graphs for each type of bond market. (12 points)

7. Throughout 2017 and 2018, the Federal Reserve reduced its growth rate of the money supply. Annualized GDP growth slowly picked up from 1.7% to around 3.8% while inflation data did not rise much. During this time, the interest rate on the 3-month Treasury bill rose from around 0.5% to 2.4%. How can we explain this? Discuss the relative importance of the liquidity, income, price-level, and expected inflation effects on interest rates. (10 points)