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Explain whether the following statements are TRUE or FALSE. State your stance clearly. a) A positive...

Explain whether the following statements are TRUE or FALSE. State your stance clearly.

a) A positive term spread is indicative of economic recession. (5 marks)

b) By reducing the required reserve ratio, the central bank can increase the monetary base and thus the money supply.

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Answer #1

a.

Answer: False

Term spread:

This is the difference of coupon rate between two bonds having different maturities, like short-term and long-term. If the long-term rate is higher than short-term rate, the term spread becomes positive and it is normal. If long-term rate is smaller than short-term rate, the term spread becomes negative and it indicates a recession in coming future. Therefore, recession is indicative if there is a negative spread and this happens out of fears and uncertainties of investors.

b.

Answer: True

An example could be taken for understanding. Suppose the demand deposit is $1,000 and the required reserve is 10%; therefore,

Money supply = Demand deposit / required reserve

                        = 1,000 / 0.10

                        = $10,000

Now, the required serve is reduced down to 8%,

Money supply = Demand deposit / required reserve

                        = 1,000 / 0.08

                        = $12,500

Therefore, these increase by reducing the required reserve ratio.

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