I. True/false questions. Briefly explain your choice to receive full credit.
1. Financial instruments used primarily to transfer risk include bonds, bank loans, mortgages and stocks.
2. Financial instruments are used primarily as stores of value and means of trading risk. They are less likely to be used as means of payment.
3. In the world without information and transaction costs, financial intermediaries would no exist.
4. Financial markets in the U.S. are more important source of funds for businesses than financial intermediaries.
5. Corporations raise funds only in secondary markets.
6. The most important characteristic an asset must have to serve the function of medium of exchange is its portability.
7. Fiat money, the kind of money used today is accepted as a medium of exchange because of its intrinsic value.
8. M1 is the component of the money supply that consists of M2 plus other relatively liquid assets.
9. If during 2013 the money supply increases by 4%, the inflation rate is 2%, and the growth of the Real GDP is 3%, then the value of velocity must fall by 1%.
10. If the money supply in a country increases, the velocity constant, then the nominal GDP in that country must also increase
11. If interest rates rise, bonds become more attractive to investors, so bond prices rise.
12. If there is a decline in interest rates, you would rather be holding short-term bonds than long-term bonds
13. The holding period return on a bond is the same as an interest rate on a bond.
14. If you own a bond and market interest rates increase, you will experience capital gain.
15. The prices of long-term bonds are less volatile than those of short-term bonds because long-term bonds respond less strongly to changes in interest rates.
16. The yield to maturity shows the earnings from holding the bond a year and then selling it.
17. A rise in expected asset income raises asset price, while decrease in interest rate reduces asset price.
18. The demand for bonds rises when expected inflation rises

II. Short-answer questions. Briefly explain your answer to receive full credit.
1. Is money the only store of value? If not, give some other examples of stores of value. Must money be a store of value to serve its function as a medium of exchange?
2. What does it mean to say that money is liquid? Explain why M1 is more liquid than M2
3. Imagine that you have just received $4,000 that you have to hold as either an M1 asset or M2 asset. What are the costs and benefits of holding the $4,000 as an M1 asset rather than as an M2 asset? Explain.
4. An article in the Economist magazine observes: â€œOne big reason to tie money to a commodity standard would be to limit its growth in order to protect against runaway inflation.â€
a. Why would tying money to a commodity limit the growth of the money supply?
b. Would doing so limit inflation? Explain
Source: â€œon Gold and Golden Agesâ€. Economist, September 11, 2012
5. It is sometimes suggested that the Fed should try to achieve zero inflation rate. If we assume that velocity is constant, does the zero- inflation goal require that the rate of money growth equal zero? If yes, explain why. If not, explain what the rate of money growth should be?
6. On January 1, 2002, Germany officially adopted the euro as its currency, and deutsche mark stopped being legal tender. According to the Article in the Wall Street Journal, even 10 years later many stores in Germany continued to accept it. Briefly explain how possible for people to continue to use a currency when government replaced it with another currency.
Source: Who needs the euro When You Can Pay with Deutsche Marks? Wall Street Journal July, 2012.
7 .Rating agencies such a Moodyâ€™s and Standard &Poorâ€™s study corporations that issue bonds. They publish â€œratingsâ€ for the bonds- evaluation of the likelihood of default. Suppose these rating companies went out the business. What effect would this have on the bond market? What effect would it have on banks?
8. In what ways are contractual savings institutions similar to commercial banks? In what ways are they different?
9. National credit bureaus collect information on peopleâ€™s credit histories. They are likely to know whether you ever defaulted on a loan. Suppose that a new privacy law makes it illegal for credit bureaus to collect information. What effect would this have on the banks? Explain
10. The United States Treasury borrows money on behalf of the federal government all the time. One type of the government borrowing, called a Treasury Bills, promises a fixed payment at some number of months in the future. The Treasury receives more for a promise to make payment of $100 in the three months than does for a promise to make a payment of $100 in the six months. Why? Explain
11. Why does a bond with longer maturity have greater interest -rate risk than a bond with shorter maturity? Explain
12. Consider two bonds; one matures in 1 year and the other matures in 30 years. What do you expect to happen to the price of each bond when the interest rate falls? When the interest rate increases? In which case do you expect the price of the bond to increase or decrease by grater percentage and why?
13. Your investment advisor has just given you the following advice: â€œLong-term bonds are a great investment because their interest rate is over 20%â€ Is he necessarily right? Explain
14. At the dinner table, your father is extolling the benefits of investing in bonds. He insists that as a conservative investor he will make only investments that are safe, and what could be safer that a bond, especially a U.S Treasury long-term bond? What accounts for his view of bonds? Explain why you think he is wrong?
15. Writing in the wall Street Journal, two economists made the following prediction: â€We believe that when investors awake from their depressed state, they will realize that they do not have to lend the U.S. government money for the 10 years at a negative real yieldâ€. By â€œnegative real yield did they mean that the nominal interest rate on 10-year Treasury notes was negative?
Explain
16. Buying an inflationâ€“indexed bond is risky. If I buy conventional bond, I know what interest rate I will receive. With indexed bond, that rate can rise or fall depending on inflation. Risk-averse savers should prefer conventional bonds. Explain
17. The president of the United States announces in a press conference that he will fight the higher inflation rate with a new anti-inflationary program. Predict what will happen to the interest rate and the bond prices if the public believes him.
18. Assume that forecasts for the U.S. economy have taken sudden turn for the worse. Everyone had expected healthy growth of 3 to 4 percent in the coming year, but now a recession set in with output contracting by as much as 4 percent. Officials expect unemployment to rise and corporate profits to plummet. Describe the consequences for the market demand for corporate bonds

III. Problems and graphing. All underlying work must be shown to receive full credit

1. Which function of money is in each of the following cases demonstrating?
(1) You pay $10 for a movie ticket.
(2) You deposit your tax refund check in your saving account.
(3) A restaurant manager sets the prices of meals she serves in dollars.
(4) A restaurant manager reports $5,000 worth of wine in the cellar.
(5) McDonaldâ€™s announces that a Big-Mac now costs only $1.00.
(6) Bill Gates net worth is around $50 billion.

2. Suppose that this yearâ€™s the money supply is $400 billions, nominal GDP is $12 trillion, and Real GDP is $6 trillion. Assume that velocity of money is constant and the economyâ€™s output of goods and services (Real GDP) rises by 4 percent each year. Use the data to answer the following questions:
All underlying work must be shown
a. What is the price level in the economy?
b. What is the money velocity in the economy?
c. What will happen to nominal GDP and the price level if the Fed keeps the money supply constant?
d. What will happen to nominal GDP and the price level if the Fed increases the money supply from 400 billions to 500 billions?
e. How many billions in the money supply should the Fed set next year if wants to keep price level stable?
f. How many billions in the money supply should the Fed set next year if it wants an inflation of 8 percent?

3. Consider the following $10,000 face -value bonds.
Bond          Coupon rate    Selling price Coupon payment Yield to maturity Current yield
A                10 percent       $9,000             _____                ______             ________
B                7 percent          $10,000          _____                ______             _________
C                9 percent          $10,000          _____                   ______             ________
D             10 percent       $8,500          ______                _______          ________
a. Compute and enter in the space provided in the table coupon payment on each bond
b. Determine the yield to maturity on each bond (you do not need to calculate the yield)
c. Which bond has the lowest yield to maturity? Which bond has highest yield to maturity? Explain why in each case?
d. Calculate and enter in the space provided in the table current yield from each bond
e. Which bond would you prefer to buy and why?
f. Refer to the bond B. If the selling price of this bond falls to$9,500, what will happen to the yield to maturity on this bond, the current yield?

4. On January 29th , 2015 you buy a bond that matures on January 29th, 2017. The face value of this bond is $100, the coupon rate of 5% and the yield to maturity of 5%.
a. How much did you pay for this bond on January 29th, 2015? Explain your answer
You receive one coupon payment and sell the bond after 1 year following the decrease in the market interest rate from 5% to 3%.
a. What would the yield to maturity on the bond you sold be?
b. What was your rate of return from this bond for the one-year holding period?
c. If the bond you sold were longer maturity would your rate of return for one-year holding period return be higher or lower? Explain
d. If inflation was 2%, what is your real rate of return for one-year holding period?

5. You purchased a perpetuity that promises annual payments of $4.You investment horizon is one year. You purchased the console when the interest rate was 5 percent and sold it a one- year later, following the fall in the interest rate to 4 percent.
a. What price did pay for this perpetuity?
b. What was the yield to maturity on this security?
c. What was your rate of return for the one-year holding period.? Was it higher or lower than the yield on this security? Why?

6. Suppose that on January 1, 2013, you purchased a bond with the following characteristics
Face value: $1,000
Maturity date: January 1, 2015
Current yield: 7.5%
Price: $850
All underlying work must be shown

a. What was the coupon payment on this bond?
b. What was the coupon rate?
c. Was the yield to maturity on this bond greater or less than current yield? Why?
d. Was the yield to maturity greater or less than the coupon rate? Why?
e. If you sold the bond on January 1, 2014, while market interest rates were 5%, what was your holding period return from this bond?
f. If the bond you sold on January1, 2014 were longer maturity, would you have received higher or lower holding period return? Explain

7. Suppose that on January 1, 2014, the price of a one- year Treasury bill is $970.87. Investors expect the inflation rate to be 2% during 2014, but at the end of the year, the inflation rate turns out to have been 1%.
a. What is the nominal interest rate on this bond?
b. What is the excepted real interest rate on this bond?
c. What is the real interest rate on this bond?
d. Do the expected real interest rate and the real interest rate differ? Explain your answer
e. Who is better off at the end of the year, lender or borrower? Explain why

8. Explain verbally and illustrate graphically how each of the events below will affect the market demand for a bond. For each event use a separate graph and shift the proper curve.
a. The Fed publishes a forecast that inflation rate will average 5% over the next five years. Previously, the Fed had been forecasting an inflation rate of 3%.
b. The economy experiences a period of rapid growth, with rising corporate profits
c. Investors believe that the level of risk in the stock market has decline.
d. The federal government imposes a tax of $10 per bond on bond sales and purchases
e. Interest rates are expected to fall.

I. True/false questions. Briefly explain your choice to receive ful...