Question 1)

During business cycle expansion, bond holders reduce the perceived

probability of a default, and increase their expectations of returns. Thus,
demand for bonds will increase business cycle expansion, and bond prices
will rise. If bond prices rise, that means yield to maturity would decrease.
Similarly, during a recession: the increase in perceived risk of failure will
deter people from buying bonds. The fall in demand for these assets will
mean that the price of bonds will fall, and the interest rate will rise.
Question 2)
An increase in the income tax rate, then, would make these bonds less
attractive and the reduction in demand for these bonds would make their
prices fall and the yield to maturity rise.
As the income tax rate increases, bond holders would find the municipal
bonds relatively more attractive. Municipal bond prices would rise, and their
yield to maturity would fall.
Question 3)
a) (1 + i)2 = (1+0.05)(1+0.1) So that i = 0.0747.
b) (1 + i)2 = (1+0.08)(1+0.03) So that i = 0.0547.
c) (1 + 0.07)2 = (1+i)(1+0.1) So that i = 0.0408
d) (1 + 0.09)2 = (1+0.05)(1+i) So that i = 0.1315
e) On two-year bonds: (1 + i)2 = (1.05)(1.06) so that i = 0.055
On three-year bonds: (1 + i)3 = (1.05)(1.06)(1.07) so that i = 0.06
On four-year bonds: (1 + i)4 = (1.05)(1.06)(1.07)(1.08) so that i = 0.065
On five-year bonds: (1 + i)5 = (1.05)(1.06)(1.07)(1.08)(1.09) so that i = 0.07
Question 4)
At the time of the speech the yield curve appeared very flat, or possibly even downward sloping.
Historically, almost every recession has been slightly preceded by an inversion of the yield
curve. In his speech, Bernanke does not foresee recession following the observation of the
flat/inverted yield curves. He distinguishes previous recession experience by looking at the level
of short term interest rates. Previous recessions have all been associated with relatively high
short-term nominal interest rates. In 2006, however, interest rates were relatively low and
Bernanke suggests other ways to explain the flat yield curve.
The expectations model of the term structure argues that that long-term interest rates
should be an average of current short-term interest rates and expected future short-term
interest rates. As a result, the yield curve would only slope downwards if expected future short
term interest rates are expected to be lower than current short term interest rates. As long-term
bond prices respond more to changes in interest rates, the returns on longer term bonds tend to be
more volatile than the returns on short term bonds in the face of interest rate variations. The term
premium is simply the increased expected return required by bond holders to accept the
additional risk associated with holding the longer term bond. This term premium suggests that

the longer the term to maturity for a bond, the higher the risk premium required. Therefore, even
if short term interest rates were expected to remain stable well into the future, we would still
expect longer term bonds to receive higher interest rates than shorter term bonds.
For given levels of the term premium, the only way we could expect the yield
to curve to
invert is if short-term interest rates are expected to fall dramatically. The
significant fall
must be enough to outweigh the term premiums that tend to make the yield
curve slope
upwards. Bernanke e claims that the yield curve reflects at most
expectations for
relatively mild reductions in short-term interest rates, but also the fact that
term
premiums have been significantly reduced over recent years. He claims that
the extreme
stability of the macroeconomic environment since the late 80s (he refers to
the Great
Moderation) has reduced the interest rate risk on longer term securities, so
that term
premiums are extremely low. Hence, he feels that the upward sloping bias in
the yield
curve has been removed, and the shape of the yield curve in 2006 predicts
nothing
unusual for short term interest rates.
Question 5)
a. Federal Funds are the reserves that banks lend to each other
overnight to help maintain their bank reserve balances.
b. The demand for federal funds depends on the amount reserves
that banks are required to hold and the amount of the excess
reserves they hold. This means that the variation in demand is
more or less dependent on the amount of excess reserves that
banks hold since all banks are required to hold a certain amount
of reserves. The federal funds rate is essentially restricted by the
reserve rate, the interest rate at which is offered by the Fed for
holding reserves. This means that the demand will be perfectly
elastic at the reserve rate because no financial institution will
want to lend reserves using the federal funds rate if it below the
reserve rate because they can gain more interest by holding
reserves at the Fed and collecting the returns of the interest rate
indefinitely by raising their excess reserves indefinitely.
Therefore, demand for federal funds depends on how far above
the reserve rate the federal funds rate is because the higher the

c.

d.

e.

f.

g.

federal funds rate the more likely banks are to lend out their
excess reserves because the returns gained from the federal
funds rate is greater than the returns from holding reserves at
the Fed. But, as the federal funds rate decreases they gain less
from lend and then demand more reserves to collect a larger
return from holding reserves at the Fed.
The supply curve for the federal funds market is perfect inelastic,
until it reaches the discount rate, the rate at which the Fed issues
loans, when it turns perfectly elastic. The supply curve is
perfectly inelastic because the amount of non-borrowed reserves
available to lend is fixed. Once the federal funds rate reaches the
discount rate, no financial institution will want to borrow from
other banks because they can borrow more cheaply at the Fed.
Therefore, no financial institution will be able to lend at a rate
above the discount rate because it would not be efficient, and
this is why the curve becomes perfectly elastic at the discount
rate.
The effect of the Feds open market sale of securities to the
banking sector on the federal funds market is that the nonborrowed reserves decrease because there are less reserves
available to lend, which causes the supply curve to shift leftward.
With all things equal, the decrease in supply of reserves will
cause the federal funds rate to increase because there are less
reserves to go around.
The Fed increasing the discount rate does effectively nothing to
the federal funds market. All that is occurs is that the ceiling of
the supply curve increases, but the equilibrium in the market
remains the same.
The Fed increasing the required reserve ratio has effects the
federal funds market by raising the interest and the nonborrowed reserves and shifting the demand for reserves.
Currently with financial institutions holding on to large amounts
of excess reserves, this does effectively nothing.
The different methods available for the Fed to use to manipulate
the federal funds rate are through Open Market Operations,
setting the discount rate, and setting the required reserve ratio.
But the Fed only uses the Open Market Operations. These Open
Market Operations are the most effective because the Fed has
complete control over them unlike with the discount rate, these
open market operations directly affect member bank behavior,
and the open market operations are precise and flexible so that
they can be used to the extent the Fed desires. Additionally,

open market operations can be easily reserved and they can be

implemented quickly.
h. The Fed would buy bonds until the federal funds rate was .25
points lower. This will increase the money base as the bank
reserves are increasing. However, the M1 money supply may
increase depending on if these new reserves are lent out and
deposited as checkable deposits or lent out as currency in
circulation. If so, the M1 money supply will increase, and if not,
the M1 money supply will not change.
Question 6)
The two approaches are similar because they both aim to have an
equilibrium that is at the same level of non-borrowed reserves, R*. However,
as the observed quantity of reserves falls below R*, the current Feds model
has will have a higher federal funds because their discount rate is higher
than the 2003 model and as the amount of reserves demand decrease the
federal funds rate increase, but the 2003 model will be restricted to the
discount rate since the discount rate is the equilibrium rate and all banks
have to option to either borrow from each other or from the Fed since no one
will borrow at a rate above the discount rate. This takes the control out of the
Feds hands. When the observed amount of reserves demanded is above R*
each model will see the federal funds rate lower until it reaches the reserve
rate.
Question 7)
Current Interest Rate on Reserves = 0.25%
Current Primary Credit Discount Rate = 0.75%
We can expect the federal funds rate to be between 0.25% and 0.75%,
potentially around 0.50%. This means that commercial banks would be
trading almost all of their excess reserves, in theory, because this estimated
federal funds rate is higher than the return they would be getting from
holding their excess reserves in the Fed from the reserve rate.
The recent observations contradict my estimations and my model. Based on
the information found on bankrate.com, the federal funds rate has been
trending at 0.25% for this past week, this past month, and this past year,
which is equal to the reserve rate. This means that almost no banks will lend
out their excess reserves because the returns gained from the federal funds
rate is equal to the returns gained from holding these reserves in the Fed. I
think that this can be explained because financial institutions are still a bit
hesitant to lend to other financial institutions as we are still escaping the

feelings of recession, and therefore, the Fed realizes this tendency and is
trying to encourage interbank lending and by keeping the federal funds rate
equal to the reserve rate there is no cost to lending or keeping reserves.
The Fed will most likely raise the interest rates by using the open market
operation of sale Treasury bonds. They will do this because they want to
increase interbank lending to get the country out of the recession and
restore faith in the financial system by eliminating the unnaturally low, nearzero interest rates to promote financial stability, and increase growth.