a) T-bills are safer than longer-term government bondsfirst because they are free of default risk, but also because they are largelyfree ofprice risk attributable to interest rate volatility - 1 mark-. This is because the price of longer-maturity bond instruments is more sensitive to interest rate fluctuations. -2 marks-.

The longer the periodfor whichyour money is tied up, the greater the capital loss or the gainfrom changes in market interest rates that are used to discount the cashflowsfrom holding

the bond, and, thus, the greater the drop (rise) in bond prices. -2 marks-.

b) Financial intermediaries by pooling resources of smaller investors benefit by carrying risk (and higher returns) at relatively low transaction costs (by building expertise through volume and by using economies of scale and scope when assessing the risk) -2 marks- and achieve significant diversification -1 mark-. Since higher-risk assets on average earn higher return,financial intermediaries can earn a profit on a diversified portfolio of risky assets -1 mark-. Similarly, individual investors benefit by earning returns on a pooled collection of assets issued byfinancial intermediaries at lower risk. -1 mark – The economies of scale allowfinancial intermediaries to provide many analytic services to

investors. -1 mark-

c) The ultimate impact on interest rates will be uncertain. On the one hand, we should expect interest rates to rise as the Treasury would need to issue more bonds in order to cover the large deficits. This would shift the supply curve of bonds to the right and the equilibrium interest rate rises. -2 marks- Increasing the amount of bonds outstanding might also increase the public’s wealth increasing the demandfor bonds and shifting the demand curve of bonds to the right. -2 marks- So, the equilibrium interest rate will depend on the magnitude of the movements of the demand and supply curves. -1 mark-

Question 2

a) The lemons problem would be less severeforfirms listed on an organised exchange such as the London Stock Exchange. -2 marks- Listed companies are larger and more reputable corporations that are closely watched by market participants. In addition, several regulations require that listed firms disclose more information about them making it easierfor investors to gather information andfigure out whether thefirm is of good quality or is a lemon reducing the adverse selection–lemons problem -3 marks-.

b) The Fed has much less control over the amount of bank reserves in the system because banks decide how much to borrowfrom thefed -2 marks-, while the public decides how much currency it wants to hold relative to deposits -2 marks-, both of which affect the amount of bank reserves. In addition,float and Treasury deposits (for example due to FX interventions) can unexpectedly change the amount of reserves in the banking system, which is essentially out of the control of the Fed -1 mark-

c) Afinancial panic would decrease the money multiplier and the money supply,for a given monetary base. In afinancial panic,you would expect banks to want to make less risky loans, and have more liquidity on hand, which would increase the excess reserve ratio and decrease the money multiplier. -3 marks- In addition, depositors may get worried about the health of banks, and increase their holdings of currency, which also would decrease the money multiplier. -2 marks-

Question 3

a) The zero lower bound on nominal interest rates makes it harder to implement expansionary policy. You cannot lowerfurther a zero nominal interest rate. -1 mark- As a result, in a low inflation environment there is less room to use monetary policy as a stabilization tool. The real interest rate is determined by expected inflation and it can be lowered (become more negative) by higher levels of expected inflation -1 mark- In this context, it is argued that a higher inflation target may be appropriate to give policymakers moreflexibility and allow more easing policy when we are at the zero lower bound (more negative real interest rates) -2 marks-. The downside of this of course is that in general higher inflation rates can be costly to society, posing a tradeofffor monetary policymakers in terms offlexibility versus efficiency of monetary policy. -1 mark- A higher inflation target might destabilise inflation expectations as the public might no longer believe in the central bank’s capacity and/or intention to maintain inflation to its target. -1 mark- So, the potential costs of higher inflation expectations might be a reason why most central banks prefer a lower inflation target, especially since zero lower bound monetary policy occurs rarely. -1 mark-

b) Both channels through which monetary policy operates posit that increases in real interest rates lead to lower asset prices, which, in turn, lead to lower spending on consumption and housing. -2 marks- The difference is in how changes in asset prices lead to lower spending. Under the wealth effect, people are simply less willing to spend when wealth is lower (due to lower overall lifetime resources), leading to a reduction in spending. -3 marks- The household liquidity effect instead indicates a substitution effect between more liquid assets (such as cash or stocks) and less liquid assets (such as consumer durables or housing). Thus, with lower asset values, households use their resources to purchase safer, more liquid assets rather than consumption or housing, leading to lower aggregate demand. -3 mark-