1. Suppose the CFO of an American corporation with surplus cash flow had $100 million to invest last July 15 and the corporation did not believe it would 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 was .5%, while the rate on 1 year CD deposits in England (denominated in British Pounds) was 2% at the time. Suppose further that the exchange rate at that time was $1.68 per British pound .

A) Suppose that now a year later the exchange rate is $1.55 per US pound. What rate of return did the CFO earn on the investment in the British CD? (Note: a specific numeric answer.)

B) What must the CFO have expected about the value of the British pound in $ today to believe that investment in British CD's was more profitable than investment in US CD's last July?

2. 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.

Explain why the Fed created all these extraordinary direct lending facilities instead of simply relying on traditional open market purchases of Treasury securities.

3. As conditions in short term financial markets improved by summer of 2009 the Fed closed down its lending under these programs. However, throughout the next 4 years the Fed increased substantially its purchases of longer term mortgage backed securities and Treasury notes from banks in a series of 3 "Quantitative Easing" (QE) Programs.

A)Assume that both lender & borrower confidence levels start to return to normal and financial and physical investment levels start to rise much more strongly in the next 12 months than in the last few years. What potential problems will the extraordinary growth in banks' reserve deposits and in the size of the Fed's portfolio of longer term Treasury and Mortgage backed bonds that has resulted from 3 rounds of Quantitative Easing create then for the Fed? 4pts

B) What relatively untested policy tools will help the Fed deal with this problem? Explain.

4. In recent weeks markets around the world have been rattled by signs of a slowdown in growth of the Chinese economy, together with a massive sell-off in its stock market... plus a massive default by Greece on its debts to the IMF , the ECB and on its government bonds which will be averted only if it agrees to harsh budget austerity measures imposed by Germany and the rest of the European Union...In the process, the value of the $ has risen against the Euro, the Yuan and many other currencies.

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 situation of the US economy.

Draw an AS/AD diagram to illustrate your answer. Clearly label axes and the current position of AS, & AD relative to full employment RGDP....also indicate any shifts that would occur if the exchange rate of the $ rose sharply against other major currencies

5. Current annualized yields on 1 year US treasury securities are only .28%....while current annualized yields on 2 year US treasury securities are .69% (note you may assume that both 1 and 2 year securities in this example are "0" coupon securities with no payment other than the maturity value on the maturity date.

What does this data suggest about financial market expectations of 1 year yields, 1 year from now? Explain.... (Assume investors are risk neutral in these short time horizons with default free treasuries.)

6. Here's a quote from Fed head Janet Yellen on at a meeting in Cleveland on July 10 this year. (see www.federalreserve.gov then click news and events...

Regarding inflation, as I mentioned earlier, the recent effects of lower prices for crude oil and for imports on overall inflation are expected to wane during this year. Combined with further tightening in labor and product markets, I expect inflation will move toward the FOMC's 2 percent objective over the next few years. Importantly, a number of different surveys indicate that longer-term inflation expectations have remained stable even as recent readings on inflation have fallen. If inflation expectations had not remained stable, I would be more concerned because consumer and business expectations about inflation can become self-fulfilling.

Explain why the FOMC is concerned not only about actual recent inflation rates as measured by the CPI, but also about longer term inflation expectations remaining "stable" In particular, what is the problem if inflation expectations start to converge to an opinion that inflation will fall to "0" or less?