EC1008: Chapter 5 questions and answers

The president of the United States announces in a press conference that he will fight the higher inflation rate with a new anti-inflation program. Predict what will happen to interest rates if the public believes him.

If the public believes the president's program will be successful, interest rates will fall. The president's announcement will lower expected inflation so that the expected return on goods decreases relative to bonds. The demand for bonds increases and the demand curve, Bd, shifts to the right. For a given nominal interest rate, the lower expected inflation means that the real interest rate has risen, raising the cost of borrowing so that the supply of bonds falls. The resulting leftward shift of the supply curve, Bs, and the rightward shift of the demand curve, Bd, causes the equilibrium interest rate to fall.

What effect will a sudden increase in the volatility of gold prices have on interest rates?

Interest rates fall. The increased volatility of gold prices makes bonds relatively less risky relative to gold and causes the demand for bonds to increase. The demand curve, Bd, shifts to the right and the equilibrium interest rate falls.

Explain what effect a large federal deficit should have on interest rates.

Interest rates should rise. The large federal deficits require the Treasury to issue more bonds; thus the supply of bonds increases. The supply curve, Bs, shifts to the right and the equilibrium interest rate rises. Some economists believe that when the Treasury issues more bonds, the demand for bonds increases because the issue of bonds increases the public's wealth. If this is the case, the demand curve, Bd, will also shift to the right, and it is no longer clear that the equilibrium interest rate will rise. Thus there is some potential ambiguity in the answer to this question.

Predict what will happen to interest rates if the public suddenly expects a large increase in stock prices.

Interest rates will rise. The expected increase in stock prices raises the expected return on stocks relative to bonds and so the demand for bonds falls. The demand curve, Bd, shifts to the left and the equilibrium interest rate rises.

Predict what will happen to interest rates if prices in the bond market become more volatile.

Interest rates will rise. When bond prices become volatile and bonds become riskier, the demand for bonds will fall. The demand curve Bd will shift to the left, the price will fall, and the equilibrium interest rate will rise.

How might a sudden increase in people's expectations of future real estate prices affect interest rates?

Interest rates would rise. A sudden increase in people's expectations of future real estate prices raises the expected return on real estate relative to bonds, so the demand for bonds falls. The demand curve Bd shifts to the left, bond prices fall, and the equilibrium interest rate rises.

What will happen to the demand for Rembrandt paintings if the stock market undergoes a boom? Why?

The rise in the value of stocks would increase people's wealth and therefore the demand for Rembrandts would rise.

In the aftermath of the global economic crisis that started to take hold in 2008, U.S. government budget deficits increased dramatically, yet interest rates on U.S. Treasury debt fell sharply and stayed low for quite some time. Does this make sense? Why or why not?

The supply effect of large deficits should lead to higher interest rates. The effects of the economic crisis lead to significantly lower wealth and income, which depressed Treasury bond demand, but also decreased corporate bond supply by even more because investment opportunities collapsed. The larger leftward shift in the bond supply curve than the rightward shift in the bond demand curve would then result in a rise in bond prices and a fall in interest rates. In addition, due to the severity of the global crisis, U.S. treasury debt became a safe haven investment, reducing relative risk and increasing liquidity for U.S. treasury debt. This significantly raised U.S. treasury bond demand, leading to higher bond prices and significantly lower yields. In other words, the decrease in investment opportunities and risk factors significantly offset the wealth effect on demand and the deficit effect on supply.

"No one who is risk-averse will ever buy a security that has a lower expected return, more risk, and less liquidity than another security." Is this statement true, false, or uncertain? Explain your answer.

True, because for a risk averse person, more risk, a lower expected return, and less liquidity make a security less desirable.

"The more risk-averse people are, the more likely they are to diversify." Is this statement true, false, or uncertain? Explain your answer.

True, because the benefits to diversification are greater for a person who cares more about reducing risk.

Why should a rise in the price level (but not in expected inflation) cause interest rates to rise when the nominal money supply is fixed?

When the price level rises, the quantity of money in real terms falls (holding the nominal supply of money constant); to restore their holdings of money in real terms to their former level, people will want to hold a greater nominal quantity of money. Thus the money demand curve Md shifts to the right, and the interest rate rises.

M1 money growth in the U.S. was about 15% in 2011 and 2012, and 10% in 2013. Over the same time period, the yield on 3-month Treasury bills was close to 0%. Given these high rates of money growth, why did interest rates stay so low, rather than increase? What does this say about the income, price-level, and expected-inflation effects?

With unusually high rates of money growth, this should lead to higher expected inflation, a jump in the overall price level, and stronger economic growth. These factors should all result in interest rates rising over time, notwithstanding the liquidity effect. However, in the period from 2011 to 2013, unemployment remained high, economic growth was weak, and if anything, policymakers were worried about deflation (a decrease in the price level) rather than any inflationary effects from the money growth. In other words, the income, price-level, and expected inflation effects of the unusually high money growth conditions were very small relative to the liquidity effect. This is similar to case (a) shown in Figure 11.

Would fiscal policymakers ever have reason to worry about potentially inflationary conditions? Why or why not?

Yes, fiscal policymakers should worry about potentially inflationary conditions. If people expect higher inflation, this increases the yield on U.S. treasury debt, meaning that the interest rates paid to debt holders increase. In other words, higher inflation leads to a higher debt service burden and increases the costs of financing deficit spending.

Will there be an effect on interest rates if brokerage commissions on stocks fall? Explain your answer.

Yes, interest rates will rise. The lower commission on stocks makes them more liquid relative to bonds, and the demand for bonds will fall. The demand curve Bd will therefore shift to the left, and the equilibrium interest rate will rise.

Explain why you would be more or less willing to buy a share of Microsoft stock in the following situations: a. Your wealth falls b. You expect the stock to appreciate in value c. The bond market becomes more liquid d. You expect gold to appreciate in value e. Prices in the bond market become more volatile

a. Less bc your wealth declines b. More bc tits relative expected return has risen c. Less bc it has become less liquid relative to bonds d. Less bc expected return is less relative to gold e. More bc it has become less risky relative to bonds

Explain why you would be more or less willing to buy gold under the following circumstances: a. Gold again becomes acceptable as a medium of exchange. b. Prices in the gold market become more volatile. c. You expect inflation to rise, and gold prices tend to move with the aggregate price level. d. You expect interest rates to rise.

a. More bc it has become more liquid b. less bc it has become more risky c. more bc its expected return has risen d. more, because its expected return has risen relative to the expected return on long-term bonds, which has declined

Explain why you would be more or less willing to buy long-term AT&T bonds under the following circumstances: a. Trading in these bonds increases, making them easier to sell. b. You expect a bear market in stocks (stock prices are expected to decline). c. Brokerage commissions on stocks fall. d. You expect interest rates to rise. e. Brokerage commissions on bonds fall.

a. more bc they have become more liquid b. more bc their expected return has risen relative to stocks c. less bc they become less liquid relative to stocks d. less bc the expected return has fallen e. more bc they have become more liquid

Explain why you would be more or less willing to buy a house under the following circumstances: a. You just inherited $100,000 b. Real estate commissions fall from 6% of the sales price to 5% of the sales price. c. You expect Microsoft 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 bc your wealth has increased b. more bc the house has become more liquid c. less bc the expected return has fallen relative to Microsoft stock d. more bc it has become less risky relative to stocks e. less bc expected return has fallen

If the next chair of the Federal Reserve Board has a reputation for advocating an even slower rate of money growth than the current chair, what will happen to interest rates? Discuss the possible resulting situations.

slower rate of money growth will lead to a liquidity effect, which raises interest rates, while the lower price level, income, and inflation rates in the future will tend to lower interest rates. There are three possible scenarios for what will happen: (a) if the liquidity effect is larger than the other effects, then interest rates will rise; (b) if the liquidity effect is smaller than the other effects and expected inflation adjusts slowly, then interest rates will rise at first but will eventually fall below their initial level; and (c) if the liquidity effect is smaller than the expected inflation effect and there is rapid adjustment of expected inflation, then interest rates will immediately fall.