Page 1 of 10 Pages

CONFIDENTIAL
turn in exam
question paper


Student Number: _________________
Student Name:___________________
Section:_________________________

Wilfrid LAURIER UNIVERSITY
Department of Economics
EC223
Economics of the Canadian Banking and Financial System
Suggested Solutions to Midterm Examination
October 25, 2010

Instructor: Sharif F. Khan

Time Limit: 1 Hour 15 Minutes

Instructions:
Important! Read the instructions carefully before you start your exam.
Mark your selections for PART A on the multiple choice answer card in PENCIL. If you make
changes, be sure to erase completely. Please record your name, student number and class section
on the multiple choice answer card. Hand in the card inside your answer booklet.
Write your answers for Part B in the booklet provided. Please record your name, student number
and class section on the answer booklet and on the exam question paper. Hand in the exam
question paper inside the answer booklet.

Marking Scheme:
Part A [30 marks] Thirty multiple-choice questions 1 mark each
Part B [25 marks] Five problem solving/ analytical questions 5 marks each


Calculators:
Non-programmable calculators are permitted

Page 2 of 10 Pages
Part A Multiple-Choice Questions [30 Marks]

Each question is worth 1 mark. There is no negative marking for wrong answers.

Answer all questions on the multiple choice answer card in PENCIL. If you make
changes, be sure to erase completely. Please record your name and student number on the
multiple choice answer card. Hand in the card inside your answer booklet.

To answer each question correctly, you have to choose the best answer from the given four
choices.

1) A

2) D

3) A

4) D

5) B

6) C

7) B

8) D

9) C

10) C

11) B

12) B

13) C

14) D

15) C

16) A

17) B

Page 3 of 10 Pages
18) B

19) C

20) D

21) A

22) B

23) A

24) C

25) A

26) B

27) D

28) A

29) D

30) C


















Page 4 of 10 Pages
Part B [25 marks]

Answer the following five questions in the answer booklet.

Each question is worth 5 marks

Read each part of the question very carefully. Show all the steps of your calculations to
get full marks.

B1. [5 marks]

Suppose that a mortgage of $400,000 is to be repaid over 25 years at an annual
interest rate of 4%. Using the formula for calculating the present value of an
annuity of n periods, find the fixed monthly payment. Show all the steps of your
calculations to get full marks.

For any fixed payment loan,

( )
( ) ( ) ( )
n
i
FP
i
FP
i
FP
i
FP
LV
+
+ +
+
+
+
+
+
=
1 1 1
1
3 2
(1)

where LV = loan value
FP = fixed payment in each period (monthly or yearly)
n = number of periods (months or years) until maturity

We can simplify equation (1) as,

( )
|
|

\
|
(

+
=
n
i
i
FP
LV
1
1
1 (2)


Calculation of fixed monthly payment:

The size of the mortgage, LV, is $400000.

The number of months until maturity, n, is 12*25 = 300.

Monthly interest rate, i, is 4%/12 = 0.0333%







Page 5 of 10 Pages
We can rewrite equation (2) as,


( )
(

=
n
i
i LV
FP
1
1
1
*


( )
(

=
300
003333 . 0 1
1
1
003333 . 0 * 400000 $
(Substituting the values for LV, i and n)


631508 . 0
003333 . 0 * 400000
=
= $2111.3474

So, the monthly fixed payment, FP, is $2111.347.

Alternative Solution 1:

We can rewrite equation (2) as,


( )
(

=
n
i
i LV
FP
1
1
1
*


( )
(

=
300
003 . 0 1
1
1
003 . 0 * 400000 $
(Substituting the values for LV, i and n)


592882 . 0
003 . 0 * 400000
=
= $2024.0108

So, the monthly fixed payment, FP, is $2024.011.











Page 6 of 10 Pages
Alternative Solution 2:

We can rewrite equation (2) as,


( )
(

=
n
i
i LV
FP
1
1
1
*


( )
(

=
300
0033 . 0 1
1
1
0033 . 0 * 400000 $
(Substituting the values for LV, i and n)


627817 . 0
0033 . 0 * 400000
=
= $2102.5229

So, the monthly fixed payment, FP, is $2102.523


Alternative Solution 3:

We can rewrite equation (2) as,


( )
(

=
n
i
i LV
FP
1
1
1
*


( )
(

=
300
00333 . 0 1
1
1
00333 . 0 * 400000 $
(Substituting the values for LV, i and n)


631141 . 0
00333 . 0 * 400000
=
= $2110.464

So, the monthly fixed payment, FP, is $2110.464








Page 7 of 10 Pages
B2. [5 marks]

(a) [3 marks]

Suppose you are given the following data:

Currency outside banks $2000
Personal deposits at chartered banks 26000
Non-personal demand and notice deposits at chartered banks 24000

Deposits at other financial institutions (TMLs, CUCPs, government-owned saving
institutions, money market mutual funds and life insurance company individual
annuities) 12000

Non-personal term and foreign currency deposits 18000

What are M2(gross), M3(gross) and M2+(gross)? Assume adjustments to the
various aggregates are zero.

M2 (gross) = Currency outside banks + Personal deposits at chartered banks+
+Non-personal demand and notice deposits at chartered banks
=$2000 + $26000 +$24000
=$52000

M3 (gross) = M2 (gross) + Non-personal term and foreign currency deposits
= $52000 + $18000
= $70000

M2+ (gross) = M2 (gross) + Deposits at other financial institutions
= $52000 + $12000
= $64000

(b) [2 marks]

Which of the Bank of Canadas measures of the monetary aggregates, M1+, M1++,
M2, M2+, M2++ or M3, is composed of the most liquid assets? Which is the largest
measure?

M1+ (gross) is composed of the most liquid assets.

M2++ (gross) is the largest measure.





Page 8 of 10 Pages
B3. [5 marks]

a) Suppose a Government of Canada zero-coupon bond can be purchased for
$4000 at the end of 2010. At maturity, in six years, the investor receives
$5500. What is the yield to maturity on this zero-coupon bond? [3 marks]


For any zero-coupon bond loan,


( )
n
i
F
P
+
=
1


where P = price of the zero-coupon bond = $4000
F = face value of the bond= $5500
n = years to maturity date = 6
i = the yield to maturity
Thus


( )
6
1
5500 $
4000 $
i +
=


( )
% 451 . 5
054509 . 0 1 054509 . 1
1 ) 375 . 1 (
) 375 . 1 ( 1
4000
5500
1
6
1
6
1
6
=
= =
=
= +
= +
i
i
i
i
i



b) Suppose you are given the following data about a T-bill: Face value
$1,000,000, current price $980,600, days to maturity, 80. What is the effective
annualized yield on this T-bill if held until maturity? [2 marks]


The effective annualized yield to maturity on any discount bond can be written as


maturity to days P
P F
i
_ _
365
*

=

where P = current price of the discount bond = $980,600
F = face value of the bond= $1,000,000
days_to_maurity = days to maturity = 80
i = the effective annualized yield to maturity
Page 9 of 10 Pages
Thus


% 026 . 9
090264 . 0
5625 . 4 * 019784 . 0
80
365
*
980600
980600 1000000
=
=
=

=
i
i
i
i


B4. [5 marks]

Using the liquidity preference framework, explain why interest rates are pro-
cyclical (rising when the economy is expanding and falling during recessions).
[Diagrams required]


Under the liquidity preference framework, when the economy booms, the demand for
money increases; people need more money to carry out an increased amount of
transactions and also because their wealth has risen. The money demand curve,
d
M ,
shifts to the right for any given level of the interest rates. In Figure 5-10 of the textbook
(page 104 of the 4
th
edition), it is shown as a rightward shift from
d
M
1
to
d
M
2
, causing an
excess demand for money at the initial equilibrium interest rate
1
i . The excess demand for
money implies an excess supply of bonds. This excess supply of bonds will lead to a
decrease in the price of bonds. As the price of bonds falls, the interest rate will rise
toward the new equilibrium interest rate
2
i . When the economy enters a recession, the
demand for money falls and the demand curve shifts to the left, lowering the equilibrium
interest rate. The liquidity preference framework thus generates an unambiguous
conclusion that interest rates are procyclical.

















Page 10 of 10 Pages
B5. [5 marks]

Explain why you would be more or less willing to buy a house under the following
circumstances:

a) You just inherited $100000.
b) Real estate commissions fall from 6% of the sales price to 5% of the sales
price.
c) You expect Air Canada stock to double in value next year
d) Prices in the stock market become more volatile.
e) You expect housing prices to fall.

(a) More, because your wealth has increased.

(b) More, because the house has become more liquid.

(c) Less, because its expected return has fallen relative to Microsoft stock.

(d) More, because it has become less risky relative to stocks.

(e) Less, because its expected return has fallen.