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Econ 380 Fall 2016 Exam 1

KEY
Name
_______________________

1) In the United States the quantity demanded of loanable funds (in Billions of Dollars) is
QdUS=8010 i , and the quantity supplied of loanable funds is QsUS=10 i10 . In the

Rest of the World, we have QdROW =10015 i and QsROW =5i20 .

a) (15points) If capital is free to flow between the countries, the equilibrium quantity of
48.75 will equal _____________ billion dollars, with excess
loanable funds exchanged worldwide
demand for domestic loanable funds equal to ____________ billion dollars Lender
-15.0 in the United
States. The United States is a _____________________ in the global loanable funds market.
Show all work.

QdWo rld =QdUS +QdROW =8010i+10015i=18025 i

s s s
QWorld =Q US +QROW =10i 10+5i20=15 i30

QdWorld =18025 i=15 i30=QsWorld

The world interest rate i = 210/40 = 5.25 and


QeWorld =18025 ( 5.25 ) =48.75 .

b) (5 points) Suppose saving in the U.S. decreases by 20 billion dollars. The world
5.75 rate will then equal ________, and excess demand for 5.0
interest loanable funds in the ROW
will equal _________ billion dollars. Show all work.
s S
We now have QUS=10 i1020=10 i30QWorld =15 i3020=15 i50

230
QdWorld =18025 i=15 i50=QsWorld i= =5.75
40

ED ROW = [10015 ( 5.75 ) ][ 5 ( 5.75 )20 ] =13.758.75=5.0


2. (15 points) Consider three interest rates that are relevant when we discuss coupon bonds:
(1) the interest yield to maturity, iYTM, (2) the coupon rate of interest, i Coupon, and (3) the
current yield, iCurrent. What is the ranking of these rates, from highest to lowest, when a
coupon bond sells at a price below par? Explain.

Ranking: iYTM > iCurrent > iCoupon


As regards the current yield and coupon rate we have (with P Bond < Par):

Coupon Coupon
i Current= > =iCoupon
P Bond Par

When we consider the yield to maturity we note that the bond holder
receives the current yield each period PLUS a capital gain when the bond
matures because he/she receives a Par payment in excess of the price paid for
the bond. Hence, iYTM > iCurrent.

3. (5 points) What is the difference between a Subprime Mortgage versus an Alt-a Mortgage?

A Subprime Mortgage is one for which the borrower has a poor credit rating.

An Alt-a Mortgage is one for which information supplied by the borrower


(regarding employment history, income, etc.) was not verified by the lender.

4. (5 points) A money may serve as a medium of exchange only if it is also a store of value.
Is this statement true or false? Explain.
TRUE!

If the money is NOT a store of value, it will NOT be readily accepted in exchange
for goods and services. Hence it cannot be a medium of exchange.
5. (10 points) Real GDP in the United States was 15,604.3 Billion (2009) dollars in 2013. The
GDP Deflator for 2013 was 106.5. The M2 money supply in 2013 was 10,740.2 billion
dollars. We can determine1.55
from this data that the velocity of M2 money was ___________in
2013. Show all work.

Nominal GDP
GDP Deflator= 100
Real GDP

GDP Deflator 106.5


Nominal GDP= Real GDP= 15,604.3=16,618.58
100 100

M V =10,740.2 V =16,618.58=P Y

16,618.58
V= =1.55
6. 10,740.2
(5 points) Harry pays $50,000 for an annuity which pays him X dollars at the end of each
3,600
year in perpetuity. The annual interest yield is 7.2 percent. We can determine that X =
________________ dollars. Show all work.

X X
50,000= t
= X=0.072 ( 50,000 )=3,600
t =1 (1+ 0.72) 0.072

7. (10 points) Suppose the government raises both personal and corporate income taxes.
Illustrate the impact of this policy on the bond market and explain how bond prices and
yields would be affected.
PBond S
S An increase in the personal income
tax reduces households disposable
income and saving. The demand for
P0
Bonds falls.

An increase in the corporate income


D D tax decreases profitability of investment
Bond in new capital. The supply of bonds falls.
s
Bond prices could fall, remain unchanged, or rise depending upon the
magnitude of these decreases in supply and demand.

We are unable to predict what will happen to bond prices and,


therefore, yields.

A final note: if these tax increases serve to decrease the


government budget deficit this will also decrease the supply of bonds.
8) You purchase a 30 year coupon bond which has par of $100,000 and a (annual) coupon
rate of 4 percent for $100,750. Looking ahead, you plan to hold this bond for one year,
collect the first coupon payment, then sell it. In the uncertain future, you expect interest
yields to maturity of 29 year bonds offering comparable risk one year from today (i t+1) will
be distributed as:

Capital Interest
Prob(it+1) it+1 Gain Return = 2.71 + 3.97
(Percent) (Percent) (Percent)
0.30 3.80 2.71 6.68
0.60 4.00 -0.74 3.23
0.10 4.20 -4.04 - 0.07

= 3.23 3.97
a) (20 points) Complete this table. Show your work below for computing the interest
return if it+1 = 4.20 percent

4,000 1 100,000
PBond ,t +1= ( 0.0420 )(1 (1+0.0420) ) (1+ 0.420)
+
29 29
=96,682.26

Interest Return=Current Yield+Capital Gain

4,000 96,682.26100,750
Interest Return= + =0.03970.0404=0.0007
100,750 100,750

b) (5 points) Given the distribution of future interest rates i t+1, we can determine that your
3.93 strategy equals ___________. You face
expected annual interest return for this investment
a standard deviation of2.04
return (a measure of risk) equal to __________. Show all work.

=0.30 ( 6.68 )+ 0.60 ( 3.23 )+ 0.10 (0.07 )=3.93

= 0.3(6.683.93)2 +0.6 (3.233.93)2+ 0.1(0.073.93)2= 4.16=2.04

For a stream of cash payments C at the end


of each of the next n years, and interest rate i:

PV = ( Ci )[ 1 ( 1+1i) ]
n

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