Explain why the Fed created all these

Running Head: ECONOMICS

 Suppose the yield to maturity on a 2 year Treasury note was 4 % while the yield on a 1 year note was 5%. Assume that neither Treasury note had coupon payments, so the only payment was the face value received when the note matured.

a) Why is it unusual for yields on longer term notes to be lower than yields on shorter term notes?

b) Why would any investor buy the 2 year note (instead of the 1 year) given its lower yield? (for full credit your answer must involve a specific number)

2) Suppose the CFO of an American corporation with surplus cash flow has $90 million to invest and the corporation does not believe it will need to utilize these funds to retool or expand production capacity for 1 year. Suppose further that the interest rate on 1 year CD deposits in US banks is .5 %, while the rate on 1 year CD deposits (denominated in Australian dollars) is currently 2.5 %. Suppose further that the exchange rate currently is (.8) Australian Dollars per US $.What must the CFO expect about the Australian Dollar/US$ exchange rate 1 year from now if she chooses to invest in the US $ CD’s instead of the Australian CD’s? (Note: a specific numeric answer is required for full credit. Part credit can be earned for correctly identifying and discussing the issue here without a specific numeric answer.)

3) Between February 2008 and Summer 2009 the Fed supplemented its open market operations with a greatly expanded program of direct lending (both overnight and short term 28 and 84 day loans) to commercial banks, investment banks, brokerage and primary dealer units of bank holding companies. It also agreed to accept a wider range of short term securities (instead of accepting only T-Bills) as collateral on these loans and even initiated a program to buy commercial paper from money market funds.

A) Explain why the Fed created all these extraordinary direct lending facilities, instead of simply relying on traditional open market purchases of Treasury securities. (hint: You may wish to look at Bernanke’s recent lecture series at GW university (on the Federal Reserve Website)---particularly the 3rd in the 4 lecture series. A link to it is on the main Federal Reserve site page)

B) As conditions in short term financial markets improved by summer of 2009 the Fed closed down its lending under almost all these programs. However, since then the Fed has engaged in 3 campaigns in which for a period of months it has increased substantially its purchases of longer term mortgage backed securities and treasury notes from banks. These programs were called “Quantitative Easing 1, 2 and 3. QE 3 has just begun this Fall and according to the Fed will be maintained until real economic growth strengthens and the unemployment rate declines.
What is the effect of these QE programs on banks’ balance sheets? Explain briefly

C) What would believers in the quantity theory of money (monetarists) expect to result from these large scale purchases of securities by the Fed? Explain your answer in a few sentences and discuss the concept of the velocity of circulation in your answer.


D) Assume that at some point in the next year or two both lender & borrower confidence levels start to return to normal and financial and physical investment levels start to rise much more strongly than in the last 2 years. What potential problem will the balance sheet effects of Quantitative Easing described in your answer to part B create then for the Fed?

How will the Fed’s relatively recent authorization to pay interest to banks on their reserve accounts at the Fed help the Fed deal with this problem? Explain.

4) At the same meeting of the open market committee where it announced Quantitative Easing 3, the Fed chose to also announce that its currently low Fed funds rate of 0 to .25% would be maintained until at least the middle of 2015. Previously it had merely said that it would keep that rate low until early 2014. Why would changing investors’ expectations that the Fed would keep the overnight Fed Funds rate at its current low level for at least 18 months longer than previously promised be helpful to the Fed at this time. (hint…think about shape of the Treasury yield curve) Explain your answer in a paragraph.

5) Given the current condition of the US economy, do you think US policy makers would 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 a stronger vs. a weaker $. Frame your answer in terms of the current Aggregate Demand and Aggregate Supply behavior of the US economy.

6) Signs of investor uneasiness in continuing to purchase treasury securities issued by heavily indebted sovereign states such as Greece and Spain have triggered a debate about raising the debt ceiling here. “Tea Party” republicans in the House of Representatives have made “out of control” government spending a rallying cry in all their political campaigns since fall 2010 and insist that any legislation to balance the federal budget over the next few years must rely solely on reductions in government spending and transfer programs with no tax increases. The republican presidential candidate in the current election repeats this party line as well. Democrats insist that some significant portion of any deficit reduction package must be based on closing tax loopholes and increasing marginal tax rates on wealthy households (income greater than $1 million). They also argue that although credible deficit reduction measures need to be put in place soon, the actual phase-in of those measures—whether tax increases or reductions in entitlement spending programs --must be gradual and await a strengthening of RGDP growth in the US economy.