Handout #2 Answer Key

Econ 330: Kelly

Fall ‘00

 

True/False/Uncertain:

 

  1. TRUE: in a business cycle expansion, with growing wealth, the demand for bonds rises and the demand curve for bonds shifts to the right. In a recession, when income and wealth are falling, the demand for bonds falls, i.e., the demand curve shifts to the left. How much demand shifts either in an expansion or in a recession depends on the elasticity of demand.

 

  1. FALSE: Higher interest rates in the future lower the expected return for long-term bonds (due to expected capital losses) and therefore decrease the demand for bonds at each interest rate, i.e., the demand curve shifts to the left. Conversely, lower expected interest rates in the future increase the current demand for bonds, i.e., shifts the demand curve to the right.

 

  1. FALSE: An increase in the expected rate of inflation lowers the expected return for bonds and therefore causes their demand to decrease, i.e., their demand curve shifts to the left.

 

  1. FALSE: If prices of bonds become more volatile, i.e., there is an increase in the risk of bonds, bonds as assets become less attractive and therefore their demand falls, i.e., their demand curve shifts to the left. Conversely a decrease in the risk of bonds increases their demand.

 

  1. TRUE: An increase in liquidity makes bonds easier to sell and therefore, other things equal, will cause an increase in the demand for bonds at every interest rate, i.e., their demand curve shifts to the right. Similarly, increases in the liquidity of alternative assets, other things equal, will lower the demand for bonds.

 

  1. TRUE: In a recession, when there are fewer expected profitable investment opportunities, the supply of bonds falls, i.e., the supply curve shifts to the left. Conversely, in a business cycle expansion, the supply of bonds will increase with the increased amount of good investment opportunities.

 

  1. TRUE: If the government deficit decreases, the excess of government expenditures over its income is less and so the government’s financial needs in the form of new bond placements decreases.

 

  1. FALSE: Using the liquidity preference framework, it is easy to see that an increase in income will raise the demand for money, and given a fixed money supply, interest rates will rise. That is, in a business cycle expansion when income is rising, interest rates will rise.

 

  1. FALSE: The demand for money is the demand for a real stock and therefore, given a constant money supply, an increase in the price level will reduce the real quantity of money causing people to increase their demand for nominal balances in order to restore the real value of their stock of money. This increase in the demand for nominal money will produce an increase in interest rates.

 

  1. TRUE: An increase in the money supply, other things constant, will imply a decrease in the interest rates, since in order for the economic agents to hold this increased amount of money, the return of alternative assets (in this case the interest rate of bonds) has to decrease.

 

  1. UNCERTAIN: As a result of an increase in the rate of growth of money supply, there will be four effects: (a) an income effect which has the effect of increasing interest rates in the long run; (b) a price level effect which has the effect of increasing interest rates in the long run; (c) an expected inflation effect, which has the effect of increasing interest rates in the long run and (d) (see question 10), a liquidity effect, which in the short run, decreases interest rates. Therefore, depending on the magnitude of the liquidity effect compared to the magnitude of the other three effects combined, we have three possible outcomes, an increase in the interest rates, no change in the interest rates or a decrease in the interest rates (in the long run).

 

  1. FALSE: If the real interest rate increases, people have the incentive to increase their future consumption, i.e. to increase their demand for bonds today and to decrease their current consumption.

 

  1. TRUE: As was already pointed out in question 12, an increase in the real interest rate implies an increase in the demand for bonds today since people has the incentive to save more today to increase their future consumption.

 

  1. TRUE: Prices and returns for long-term bonds are more volatile than those for shorter-term bonds. Investments in long-term bonds are quite risky due, among other things, to interest rate risk.

 

  1. FALSE: The interest rate of a bond is generally thought as the yield-to-maturity for that bond. The return of a bond takes into consideration the possibility of holding the bond for a period that is different than the whole maturity period of the bond and therefore possible changes in the price of the bond have to be taken into consideration when calculating the return of that bond. In other words the return of the bond not only includes the interest rate earned in the bond but also the possible capital gains or losses due to differences in the buying and selling prices.

 

  1. FALSE: The current yield only equals the yield to maturity when the bond price is at par.  Both are concepts of interest rates, however.

 

  1. FALSE: See number 15, which is the same question.

 

  1. TRUE: For discount bonds and zero-coupon bonds that make no intermediate cash payments before the holding period is out, the price at the end of the holding period is already fixed at the face value.  Changes in interest rates, then can have no effect on the price at the end of the holding period, and the return will therefore be equal to the yield to maturity known at the time the bond is purchased.

 

  1. TRUE: The discount yield has as one of its terms the difference between the face value and purchase price of the discount bond.  Because the purchase price necessarily decreases relative to the face value as the maturity increases, the percentage gain on the face value necessarily becomes a worse approximation to the percentage gain on the purchase price as the maturity increases.

 

  1. FALSE: This depends on how you diversify.  Constructing a portfolio with a beta of 2.0, for instance, increases your risk.  More generally, if assets are highly positively correlated, diversification does little or no good to the risk-averse investor.

 

Other Questions:

 

  1. A number of responses are possible.  One consideration is that the higher the interest rate, the higher the opportunity cost of money – an individual would want to stay as fully invested as possible, while still having enough liquid assets to cover expenses.

 

  1. The longer the maturity, the greater the price risk.  The longer the maturity, the lower the reinvestment risk.

 

  1. No, to the extent that U.S. individuals and corporations are subject to income taxes.  One wants to look at the after-tax real rate.

 

  1. No difference – the interest rate (yield to maturity) of a consol is the coupon payment divided by the price of the consol.  This is precisely the current yield on the consol.

 

  1. Two benefits: (1) interest and principal are not eroded by inflation, and (2) they generate direct information on expected inflation (via subtracting the nominal rate).  A cost is that the bonds are not indexed for taxation – when the interest and principal increase, the bearer’s tax payments also increase.

 

  1. When the coupon bond is priced at its face value, the yield to maturity equals the coupon rate.

 

  1. The price of a coupon bond and the yield to maturity are negatively related.

 

  1. Initially, the real interest rate is (5-2)=3%, but the expected real rate in the future is (10-9)=1%.  The real cost of borrowing is expected to decrease… borrowing should increase.

 

  1. Income and the price level cause the demand curve for money to shift in Keynes’ liquidity preference analysis.  Income: as an economy expands and income rises, wealth increases and people will want to hold more money as a store of value; also, people will want to carry out more transactions using money, with the result that they will also want to hold more money.  Price level: when the price level rises, the same nominal quantity of money is no longer as valuable; to restore their holdings of money in real terms to its former level, people will want to hold a greater nominal quantity of money.

 

  1. Liquidity effect: an increase in the money supply, ceteris paribus, lowers the interest rates.  Basically, supply goes up, so the price of money goes down.  Income effect: an increase in the money supply is expansionary, so raises both national income and wealth, which leads to higher interest rates.  Price-level effect: an increase in the money supply is inflationary, which leads to an increase in the interest rate.  Expected-inflation effect: the rising price level also affects the expected inflation rate… people see higher prices and expect continuing inflation.  This results in an increase in the interest rate.