Practice Questions for final exam – Econ 351 – Spring 2005 ...



Practice Questions for final exam – Econ 351– set 3

True / False (Answer A for true and B for false)

1. NAIRU is defined as the rate of inflation at which we expect unemployment to begin increasing.

2. According to the Fisher effect, higher real rates of interest cause inflation to go down due to weaker aggregate demand.

3. It takes longer for Fiscal Policy authorities to turn the implement policy than it does for Monetary Authorities.

4. The main measure of inflation used by the Fed to gauge inflationary pressures is the headline inflation number, the CPI (consumer price index)..

5. We argued, using the Taylor Rule, when the federal funds rate falls below 3%, Fed policy is considered easy (accommodative).

6. According to the Fisher effect, if inflationary expectations rise, then real rates of interest will rise as well.

7. During the late 1990s, the unemployment rate in the US fell below 4 percent!

8. By overheating, we mean either that the unemployment rate is too low or GDP growth is too fast, or a combination of both.

9. If the current price of a US Treasury bond is 110, then that bond is selling at a premium.

10. The Fed's inflation target of 2% refers to the over all rate PCE rate inflation as opposed to the PCE core rate of inflation.

11. One reason the bond market rallies is the safe haven argument – that is, when the financial waters get rough and murky, investors tend to prefer the safe haven of US Treasuries.

12. If I expect interest rates to rise in the future, then I should sell bonds now.

13. If the spread between rates on Ford bonds and comparable US Treasuries rises then we say that the risk premium on Ford bonds has risen.

14. The risk structure of interest rates is

A) the structure of how interest rates move over time.

B) the relationship among interest rates of different bonds with the same maturity.

C) the relationship among the term to maturity of different bonds.

D) the relationship among interest rates on bonds with different maturities.

15. Which of the following long-term bonds has the highest interest rate?

A) Corporate Aaa bonds B) U.S. Treasury bonds

C) Corporate Aa bonds D) Corporate Baa bonds

16. The risk premium on corporate bonds becomes smaller if

A) the riskiness of corporate bonds increases.

B) the liquidity of corporate bonds increases.

C) the liquidity of corporate bonds decreases.

D) the riskiness of corporate bonds decreases.

E) both (b) and (d) occur.

17. If the expected path of one-year interest rates over the next four years is 5 percent, 4 percent, 2 percent, 1 percent, then the expectations theory predicts that today's interest rate on the four-year bond is

A) 1 percent. B) 2 percent. C) 3 percent. D) 4 percent. E) 5 percent.

18. If the yield curve is flat for short maturities and then slopes downward for longer maturities, the liquidity premium theory (assuming a mild preference for shorter-term bonds) indicates that the market is predicting.

A) a rise in short-term interest rates in the near future and a decline further out in the future.

B) constant short-term interest rates in the near future and a decline further out in the future.

C) a decline in short-term interest rates in the near future and a rise further out in the future.

D) a decline in short-term interest rates in the near future and an even steeper decline further out in the future.

19. Technical analysts try to find patterns in stock prices by looking at charts and thus, are often referred to as chart watchers.

20. In class we argued that long rates react more to changes in inflationary expectations relative to short rates. This higher volatility helps explain why the yield curve is ‘typically’ upward sloping.

21. The liquidity premium theory of the term structure helps explain why on average, the Treasury yield curve typically slopes upward. The liquidity premium theory relies on the fact that the longer the maturity, the less liquid the bond and thus, the higher the interest rate (lower the price), since investors require a ‘liquidity premium’ in order to purchase the longer-term security.

22. Quantitative easing (QE) arguably works through the term premium, the more the QE, the lower the term premium and the lower the long term interest rate.

23. The risk structure of interest rates is

A) the structure of how risks in buying bonds move over time.

B) the relationship among interest rates of different bonds with the same maturity.

C) the relationship among the term to maturity of different bonds.

D) the relationship among interest rates on bonds with different maturities.

24. The risk premium on corporate bonds (yield on corporate’s minus yield of Treasuries) becomes smaller if

A) the riskiness of corporate bonds increases.

B) the liquidity of corporate bonds increases.

C) the liquidity of corporate bonds decreases.

D) the riskiness of corporate bonds decreases.

E) both (b) and (d) occur.

25. If productivity growth falls and with it, inflationary expectations rise, then the bond market should rally (according to the Fisher effect).

26. The slope of the yield curve has gotten more reliable, through time, in terms of its ability to predict recessions (i.e., it has improved through time as a reliable forward economic indicator).

27. According to a previous HW assignment on the yield curve, the slope of the yield curve is typically higher during recoveries than it is during recessions.

L = - [α (π-π*)2 + β ( y-y*)2 ]

28. According to the loss function above, where the variables and parameters are defined as in class, missing your inflation target by 100 basis points on the upside is just as costly to social welfare as missing your inflation target by 100 basis points on the downside.

29. According to the loss function above, Paul Volcker’s β is bigger than his α consistent with the notion that Paul Volcker is an inflation hawk.

30. We discussed that in the context of the loss function above, all policy makers have their own personalized α’s and β’s and that what really matters is their relative magnitude. That is, we argued that if α/β is greater than 1, then the policymaker is considered to be dovish and would more than likely vote for policy easing in a stagflation environment relative to a hawk, whose α/β is less than one.

31. According to the original Taylor rule, if we are hitting our target for inflation and GDP growth, then the federal funds rate should be set at 4%

32. The Taylor principle is a principle of fighting inflation by raising nominal interest rates faster than inflation rises so that the real federal funds rate rises. For example, if the actual inflation rate rises by 100 basis points then the Taylor principle tells us to raise the federal funds rate by more than 100 basis points, all else constant.

33. The 2003 – 2004 period was when Alan Greenspan arguably had interest rates too low for too long as he (and the FOMC) set the federal funds rate target at 1%. Taylor (from the Taylor rule) argues that this rate (1%) was below the implied fed funds rate from the Taylor rule. Given that GDP was at potential (target) and that actual inflation was 1% where the target or optimal inflation rate is 2%, the Fed, according to the Taylor rule should have had the federal funds target set at 2%.

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