Economics 330

Spring 2002

Answers to First Midterm: Version 1

Multiple Choice:

1. E

2. D

3. C

4. E

5. E

6. B

7. A

8. A

9. D

10. A

11. B

12. A

13. A

14. B

15. E

16. C

17. C

18. E

19. A

20. E

Problems:

1. The supply of loanable funds curve shifts to the left due to the decrease in liquidity while the demand for loanable funds curve shifts to the right due to the increased profitability of investment opportunities. Thus, we know for sure that interest rates increase and bond prices fall, but we cannot know with certainty whether or not the equilibrium quantity of bonds increases, decreases, or remains the same.

2. a. The expected rate of return is 11%.

b. Using the standard deviation measure of risk, risk has a value of 8.31%

3. The nominal interest rate in year one, using the simple Fisher equation, is 6.5%. Setting the bond price of $1050 equal to the sum of the present value of the stream of payments and solving for the nominal interest rate in year 2 yields a nominal interest rate of 8.03% in year 2. In order for the real return in year 2 to be 4%, then the expected inflation rate in year 2 must be 4.03% (again, using the simple Fisher equation).

Essay:

1. a. Three distinct advantages include 1) reducing the costs of exchange; 2) reducing the exchange rate uncertainty; 3) preventing competitive devaluations; and 4) preventing speculative attacks.

b. Primary disadvantages include 1) countries cede their rights to set monetary policy to respond to domestic economic problems; 2) no more adjustment of exchange rates in response to regional problems; and 3) EU agreed to limit the use of fiscal policies.

c. Looking at the expression of your argument.