Lecture 2 problem set Flashcards
(16 cards)
If wealth increases, the demand for stocks ________ and that of long-term
bonds ________, everything else held constant
increases; increases
Holding everything else constant the more liquid is asset A, relative to alternative assets, the
_______ will be the demand for asset A.
greater
A decrease in the brokerage commissions in the housing market from 6%
to 5% of the sales price will shift the ________ curve for bonds to the
________, everything else held constant
demand, left
Deflation causes the demand for bonds to ________, the supply of bonds
to ________, and bond prices to ________, everything else held constant.
B) increase; decrease; increase
When the interest rate on a bond is ________ the equilibrium interest rate,
in the bond market there is excess _________ and the interest rate will
________.
B) above; demand; fall
A ________ is bought at a price below its face value, and the ________
value is repaid at the maturity date.
D) discount bond; face
The demand curve for bonds would be shifted to the left by an…
– A) …increase in the liquidity of bonds relative to other assets.
– B) …increase in expected returns on bonds.
– C) …increase in expected inflation.
– D) …increase in wealth.
C) …increase in expected inflation.
During a period of economic expansion, when expected profitability is
high…
– A) …the equilibrium price of bonds rises.
– B) …the supply curve of bonds shifts to the right.
– C) …the equilibrium interest rate falls.
– D) …the demand curve for bonds shifts to the left.
B) …the supply curve of bonds shifts to the right
Your favourite uncle advises you to purchase long-term bonds because
their interest rate is 10%. Should you follow their advice?
It depends on where you think interest rates are going to be in the
future. If you think interest rates will be going up, you should not follow your
uncle’s advice. The lower price implies a capital loss if you need to sell it
before the maturity date. Long-term bonds have a greater interest-rate risk.
What would be the implications for interest rates (which are determined
in the bond market) when the economy goes through a business cycle
contraction
In a business cycle contraction, wealth decreases; which is one the main
determinants of the demand of assets. The quantity demanded for bonds for
each price is now lower. This implies a shift of the demand curve for bonds to
the left; creating an excess supply. Market forces drive the price down, and
the interest rate increases.
On the supply side, we expect a decrease in expected profitability in a
business cycle contraction. The quantity supplied for each bond price
decreases; a shift of the supply curve to the left; creating an excess demand.
This induces exactly the opposite effect on prices (and on the interest rates).
■ Thus, the overall effect is ambiguous and depends on the slopes of the curves
and the magnitudes of the changes.
■ In general, empirical evidence show that interest rates tend to decrease during
recessions; so that the supply-side channel prevails. We draw the figure
accordingly. Refer to word:
What would be the implications for interest rates (which are
determined in the bond market) when the public expects a large
increase in stock prices?
A key determinant of the demand for an asset is the expected return on this
asset relative to alternative assets. In this case the expected return on the
alternative (to bonds) asset (i.e., stocks) increases as the stock prices
increase; hence the expected return of bonds relative to alternative assets
decreases.
■ Thus, the quantity demanded for each price decreases. The demand curve
shifts to the left; there is an excess supply in the market; so, bond price
decreases due to market forces; and the interest rate increases.
The demand curve shifts to the left.
Excess supply makes the price to fall to 𝑃1∗.
New equilibrium at point C.
There, the interest rate is greater than before; i.e.
𝑖1∗ > 𝑖0∗
Assess the impact on the bond market of the rise in the trading of
stocks through the internet
An increase in the trading of stocks through the internet increases the
liquidity of the stock market; stocks become more liquid.
■ This makes bonds relatively less liquid in comparison to stocks; hence the
demand for bonds shifts to the left.
■ This creates an excess supply of bonds, and market forces lead to a
decrease in the price of bonds; hence an increase in their yields.
■ Exactly the same graph as before (Analytical Question 3 – Answer).
Using the demand/supply framework for bonds and the market for
gold framework, describe the implications of an increase in expected
inflation on interest rates on bonds and the price of gold. Draw the
necessary graph(s).
numbers not represented properly on slides:
For bonds, the analysis follows Lecture 2, presentation slide 20.
– Expected return of gold (physical asset) ↑→ demand for bonds ↓; excess
supply.
– Real cost of borrowing ↓→ supply of bonds ↑; excess supply.
■ The price decreases (due to market forces) and the interest rate increases.
■ For gold, the analysis follows Lecture 2, presentation slides 27-28.
– Expected inflation ↑ → 𝑃𝑡+1
𝑒 ↑ → 𝑅𝑒 ↑ → demand curve shifts to the right →
excess demand for gold → 𝑃 ↑
Assume that consumers’ marginal propensity to consume decreases.
Explain the impact to the interest rates on bonds, using the market for
bonds framework, and draw the necessary graph(s).
A decrease in the marginal propensity to consume implies an increase in
the marginal propensity to save; which means an increase in wealth.
■ Wealth is a determinant of the demand for bonds; hence an increase in
quantity demand at each price; hence a shift of the demand curve to the
right; hence an excess demand of bonds is created.
■ Market forces drive the price up; hence new equilibrium at a lower interest
rate.
Graph
The demand curve shifts to the right.
Excess demand makes the price to increase to 𝑃1∗.
New equilibrium at point C.
There, the interest rate is lowerer than before; i.e.
𝑖1∗ < 𝑖0∗
he demand and supply curves for an one-year discount bond with a face
value of £1,000 are represented by the following equations:
– 𝑃 = −0.5 ∗ 𝑄𝑑 + 1,050
– 𝑃 = 𝑄𝑠 + 600
where 𝑃 defines the price, 𝑄𝑑 quantity demanded and 𝑄𝑠 quantity supplied.
■ What is the equilibrium price and quantity of bonds in this market? Draw
the necessary graph.
■ What is the interest rate in this market?
Not represented properly
Market equilibrium: 𝐵𝑑 = 𝐵𝑠 ⇒ 𝑄𝑑 = 𝑄𝑠
■ ቊ𝑃 = −0.5 ∗ 𝑄 + 1,050
𝑃 = 𝑄 + 600 ⇒ ቊ𝑄 + 600 = −0.5 ∗ 𝑄 + 1,050
𝑃 = 𝑄 + 600 ⇒ ቊ𝑄∗ = 300
𝑃∗ = 900
For an 1-year discount bond: 𝑖 = 𝐹−𝑃
𝑃 . The face value is £1,000 and we have
already computed the equilibrium price. Thus:
– 𝑖∗ = 𝐹−𝑃
𝑃 = 1000−900
900 = 11.1%
