ECON 215 EXAM 2

the expectations theory

"The interest rate on a long-term bond will equal an average of the short-term interest rates that people expect to occur over the life of the long-term bond." 2x one-year bonds versus 1x two-year bond ex: if people expect that short-term interest rates will be 10% on average over the coming five years, the expectations theory predicts that the interest rate on bonds with five years to maturity will be 10% too. If short term interest rates were expected to rise even higher after this five year period so that the average short term interest rate over the coming 20 years is 11% then the interest rate on 20 year bonds would equal 11% and would be higher than the interest rate on five year bonds.

risk

(the degree of uncertainty associated with the return) on one asset relative to alternative assets

liquidity

(the ease and speed with which an asset can be turned into cash) relative to alternative assets

expected return

(the return expected over the next period) on one asset relative to alternative assets

liquidity premium theory

-combination of segmented markets and expectations theories "The interest rate on a long-term bond will equal an average of short-term interest rates expected to occur over the life of the long-term bond plus a liquidity premium (also referred to as a term premium) that responds to S&D conditions for that bond." ~*preferred habitat theory* ~yeild curve

default risk

-occurs when the issuer of the bond is unable or unwilling to make interest payments when promised or pay off the face value when the bond matures

segmented markets theory

-sees markets for different maturity bonds as completely separate "The interest rate for each bond with a different maturity is then determined by the S&D for that bond, with no effects from expected returns on other bonds with other maturities." -this is the opposite extreme to the expectations theory, which assumes that bonds of different maturities are perfect subsitutes

risk premium

-the spread between the interest rates on bonds with default risk and default-free bonds of the same maturity -indicates how much additional interest people must earn to be willing to hold that risky bond -S&D market of bonds: bonds with default risk always has a positive risk premium (the higher the default risk, the larger the risk premium will be)

The liquidity premium and preferred habitat theories explain the following 3 facts:

1. Interest rates on bonds of different maturities tend to move together over time. 2. When short term interest rates are low, yield curves are more likely to have a steep upward slope 3. yield curves usually slope upward, but when short-term interest rates are high, yield curves are more likely to be inverted

3 theories that explain the term structure of interest rates (or the relationship among interest rates on bonds of different maturities reflected in yield curve patterns:

1. the expectations theory 2. the segmented markets theory 3. the liquidity premium theory

Assume that the liquidity effect is larger than the aggregate of the​ income, price​ level, and expected inflation effects. Select the graph which shows the change in interest rates when the growth rate of money supply increases.

A

The liquidity is effect larger than the other​ effects:

A

There is a perceived increase in the riskiness of bonds. Which market is likely to represent corporate Baa​ bonds? Which market is likely to represent the​ 10-year Treasury​ note?

A and C

Suppose that the liquidity effect is immediate and smaller than the other​ effects, and our expectations of inflation adjust slowly.Referring to the graphs on the​ right, choose the time path of interest rates from an increase in the growth rate of the money supply that occurs at time​ "T."

A.

The president of the US 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

As a result of the​ president's announcement,​ people's expectations of inflation will fall​, which causes the demand for bonds to shift to the right. ​However, the lower expected inflation rate causes the cost of borrowing to rise​, so the supply of bonds will decrease​, which causes the supply curve for bonds to shift to the left.The impact of this change in bond demand and supply will cause equilibrium interest rates to decrease.

The liquidity effect is smaller than the other effects and there is a slow adjustment of expected​ inflation:

B

​A decrease in expected inflation causes

Bond demand to increase, bond supply to decrease, I.R to fall

The liquidity effect is smaller than the​ expected-inflation effect and there is fast adjustment of expected​ inflation:

C

Which of the following will cause interest rates to​ rise? A. People reduce their expectations of inflation. B. The stock market has become more volatile. C. The government increases its budget deficit. D. Firms become pessimistic about the future profitability of new plant and equipment.

C. The government increases its budget deficit. .

Risk premiums on corporate bonds are usually anti-cyclical; that is they decrease during business cycle expansions and increase during recessions? Why?

During business cycle booms, fewer corporations go bankrupt and there is less default risk on corporate bonds, which lowers their risk premium. Similarly, during recessions, default risk on corporate bonds increases and their risk premium increases. The risk premium on corporate bonds is thus anticyclical, rising during recessions and falling during booms.

Given the business cycle contraction has resulted in a lack of profitable investment opportunities in the private​ sector, which of the following would potentially be a stimulus to the Japanese economy and would raise interest​ rates?

If the government runs large deficits to fund new infrastructure​ projects, it would issue debt to finance these deficits. This would increase the supply of​ bonds, which would raise interest rates.

If yield curves, on average, were flat, what would this say about the liquidity premiums in the term structure? Would you be more or less willing to accept the pure expectations theory?

If yield curves on average were flat and the risk premium on long-term relative to short term bonds were positive then one would expect interest rates to fall more often than rise. Given that rates are as likely to rise as to fall this would force the risk premium to be zero. Thus we would be more willing to accept the pure expectations theory.

If yield curves, on average, were flat, what would this say about the liquidity (term) premiums in term structure? Would you be more or less willing to accept the expectations theory?

If yield curves on average were flat, this would suggest that the risk premium on long-term relative to short-term bonds would equal zero and we would be more willing to accept the expectations hypothesis.

When the Fed wants to raise the expected​ inflation, it should ____________ the growth rate of the money supply.

Increase

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

Interest rates will rise.

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

Interest rates would increase because real estate would have a relatively higher rate of return compared to​ bonds, which would cause the demand for bonds to decrease.

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, and the equilibrium bond price falls, so the interest rate rises.

What will happen in the bond market if the government imposes a limit on the amount of daily​ transactions? Which characteristic of an asset would be​ affected?

Liquidity of bonds relative to other assets will​ decrease, increasing the interest rate and lowering​ bond's prices.

Suppose you are in charge of the financial department of your company and you have to decide whether to borrow short or long term. Checking the​ news, you realize that the government is about to engage in a major infrastructure plan in the near future. Predict what will happen to interest rates.

Since the government is a major player in the market for​ bonds, this will most likely result in a shift to the right in the supply​ curve, lowering the price of bonds and increasing interest rates.

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?

Slower money growth will lead to a liquidity​ effect, which will raise interest​ rates; however, the lower​ income, price​ level, and inflation will tend to lower interest rates.

Step 1: An increase in default risk shifts the demand curve for corporate bonds ______ Step 2: and shifts the demand curve for Treasury bonds to the _____ Step 3: which _______ the price of Treasury bonds and _______ the price of corporate bonds, and therefore _______ the interest rate on Treasury bonds and ______ the rate on corporate bonds, thereby __________ the spread (*risk premium*) between the interest rates on corporate versus Treasury bonds.

Step 1: left Step 2: right Step 3: raises, lowers, lowers, raises, increasing (figure 2)

Step 1: Tax-free status shifts the demand for municipal bonds to the _______ Step 2: and shifts the demand for Treasury bonds to the _______ Step 3: with the result that municipal bonds end up with a ________ price and a ________ interest rate than on Treasury bonds.

Step 1: right Step 2: left Step 3: higher, lower

Which should have the higher risk premium on its interest rates, a corporate bond with a Moody's Baa rating or a corporate bond with a C rating? Why?

The bond with a C rating should have a higher risk premium because it has a higher default risk, which reduces its demand and raises its interest rate relative to that of the Baa bond.

The figure to the right depicts the bond market. Show what will happen to interest rates if prices in the bond market become more volatile.

The effect of this shock will likely cause bond yields to increase

Suppose there is a downward revision of inflation expectations. Show the effect on the bond market.

The effect of this shock will likely cause bond yields to decrease.

Explain the effect that a large federal deficit will have on interest rates.

The effect of this shock will likely cause interest rates to increase

If a yield curve looks like the one shown here, what is the market predicting about future short-term interest rates? What might the yield curve indicate about the inflation rate in the future?

The flat yield curve at shorter maturities suggests that short-term interest rates are expected to fall moderately in the near future, while the steep upward slope of the yield curve at longer maturities indicates that interest rates further into the future are expected to rise. Because interest rates and expected inflation move together, the yield curve suggests that the market expects inflation to fall moderately in the near future but to rise later on.

Predict what will happen to interest rates on a corporation's bonds if the federal government guarantees today that it will pay creditors if the corporation goes bankrupt in the future. What will happen to the interest rates on Treasury securities?

The government guarantee will reduce the default risk on corporate bonds, making them more desirable relative to Treasury securities. The increased demand for corporate bonds and decreased demand for Treasury securities will lower rates on corporate bonds and raise them on Treasury bonds.

Suppose that many big corporations decide not to issue​ bonds, since it is now too costly to comply with new financial market regulations. Can you describe the expected effect on interest​ rates?

The impact will translate into a shift to the left in the supply​ curve, increasing​ bond's prices​ (lowering interest​ rates) and lowering the quantity of bonds bought and sold in the market.

Suppose that people in France decide to permanently increase their savings rate. Predict what will happen to the French bond market in the future. Can France expect higher or lower domestic interest​ rates?

There will be an increase in​ wealth, creating a shift to the right in the demand curve for bonds in France. France can therefore expect permanent lower interest rates in the future.

M1 money growth in the U.S. was about​ 16% in​ 2008, 7% in​ 2009, and​ 9% in 2010. Over the same time​ period, the yield on​ 3-month Treasury bills fell from almost​ 3% to close to​ 0%. Given these high rates of money​ growth, why did interest rates​ fall, rather than​ increase?

The​ income, price-level, and​ expected-inflation effects were small relative to the liquidity effect.

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 than bonds, and the demand for bonds will fall. The demand curve Bd will therefore shift to the left, and the equilibrium bond price falls and the interest rate will rise.

Will you advise borrowing short or long​ term?

You would recommend locking in a​ long-term loan at the current interest rate.

yield curves

a plot of the yields on bonds with differing terms to maturity but the same risk, liquidity, and tax considerations that describes the term structure of interest rates for particular types of bonds

portfolio theory

an economic theory that outlines criteria that are important when deciding how much of an asset to buy

Using the liquidity preference​ framework, an increase in the riskiness of bonds will​ cause:

an increase in the demand for​ money, no change in the quantity of​ money, and a higher interest rate.

In the theory of portfolio​ choice, which of the following will increase the quantity demanded of an​ asset?

an increase in the liquidity of the asset relative to alternative assets

An important way in which the Federal Reserve decreases the money supply is by selling bonds to the public. Using a supply and demand analysis for​ bonds, show what effect this action has on interest rates.

bond prices decrease and interest rates​ (bond yields) increase

junk bonds

bonds with ratings below Baa or BBB have higher default risk

investment-grade securities

bonds with relatively low risk of default and have a rating of Baa or BBB and higher

A business cycle expansion causes

both bond demand and bond supply to shift right.

In the long​ run, if the​ output, price-level, and expected inflation effects outweigh the liquidity​ effect, to reduce interest rates the Federal Reserve should

decrease the growth rate of the money supply.

If the supply of bonds shifts to the right the price of bonds __________ and the interest rate ________

decreases, increases

liquidity preference framework

determines the equilibrium interest rate in terms of the supply of and demand for money rather than the supply of and demand for bonds

asset market approach

emphasizes stocks of assets, rather than flows, in determining asset prices-- is the dominant methodology used by economists

An increase in the money​ supply, other things held​ constant, causes interest rates to

fall

Suppose there is an increase in the growth rate of the money supply. If the liquidity effect is smaller than the income, price-level, and expected inflation effects, and if inflationary expectations adjust slowly, then in the short run, interest rates __________.

fall

if the corporate bond becomes less liquid than the treasury bond because it is less widely traded, then (as the *theory of portfolio* choice indicates) demand for it will ____ shifting its demand curve _____. The Treasury bond now becomes relatively _____ liquid in comparison with the corporate bond, so its demand curve shifts ______. The shifts in the curves show that the price of the less liquid corporate bond ____ and its interest rate _____, while the price of the more liquid treasury bond ______ and its interest rate _____. The result is that the spread (*risk premium*) between the interest rates on the two bond types has risen. therefore the differences between interest rates on corporate bonds and treasury bonds reflect not only the corporate bond's risk but also its liquidity. *This is why a risk premium is more accurately a "risk and liquidity premium"*

fall, left more, right falls, rises, rises, falls

Suppose there is an increase in the growth rate of the money supply. If the liquidity effect is smaller than the​ income, price-level, and expected inflation​ effects, and if inflationary expectations adjust​ slowly, then in the short​ run, interest rates

fall.

When the Federal Reserve decreases the growth rate of the money supply, the income effect causes the interest rate to __________ while the liquidity effect drives the interest rate __________.

fall; up

If there is a decrease in the growth rate of the money​ supply, the resulting liquidity effect is larger than the combined​ income, price-level, and expected inflation​ effects, and inflationary expectations adjust​ quickly, then the interest rate will

immediately rise and then fall over​ time, but will remain higher than its original level.

Suppose uncertainty about the future will lead investors to move to the short end of the market. As a​ result, the difference between​ short-term and​ long-term bond yields will _________

increase

a rise in the riskiness of bonds will cause the interest rate in the liquidity preference framework to ________ and cause the interest rate in the bond market to ______ .

increase

Using the diagram to the​ right, representative of a primary bond​ market, show the effects of an increase in household wealth and an increase in expected profitability of investments.Given how interests typically behave during a business cycle​ expansion, the effect of this shock is likely to

increase bond yields

Based on empirical​ evidence, because interest rates ______ when the economy is​ expanding, interest rates are said to be __________ .

increase, procyclical

Along the supply curve for​ bonds, a decrease in the price of bonds

increases the interest rate and decreases the quantity of bonds supplied.

credit-rating agencies

investment advisory firms that rate the quality of corporate and municipal bonds in terms of the probability of default

municipal bonds are _______ liquid than US treasury bills but why then do they have ______ interest rates?

less, lower interest payments on municipal bonds are exempt from federal income taxes, a factor that has the same effect on the demand for municipal bonds as an increase in their expected return

What will happen in the bond market if the government imposes a limit on the amount of daily transactions? Which characteristic of an asset would be affected?

liquidity

when yield curves are inverted....

long term interest rates are below short term interst rates

A decrease in the price level causes

money demand to shift to the​ left, and interest rates decrease.

A bond with default risk will always have a __________ risk premium, and an increase in its default risk will ________ the risk premium

positive, raise

excess demand

quantity demanded is greater than quantity supplied

If the Fed is only concerned about the​ short-run economy the liquidity effect is smaller than the other effects and expected inflation adjusts​ slowly, then to lower the​ short-run interest​ rates, the Fed should always ___________the growth rates of the money supply.

raise

Suppose there is​ an increase in the growth rate of the money supply. If the liquidity effect is smaller than the​ output, price-level, and expected inflation​ effects, then in the long​ run, interest rates

rise when compared to their initial value

When the Fed increases the growth rate of the money supply, the price level effect drives the interest rate __________ while the expected inflation rate pushes the interest rate to __________

rise; rise

____, __________, and ______________, all play a role in determining the *risk structure of interest rates*

risk, liquidity, and income tax rules (and a bond's term to maturity)

When the federal government sells a Treasury bond in the primary market - via Treasury auction, it is

seeking to finance government spending as an alternative to raising taxes.

when yield curves are flat...

short and long term interest rates are the same

demand curve

shows the relationship between the quantity demanded and the price when all other economic variables are held constant

supply curve

shows the relationship between the quantity supplied and the price when all other economic variables are held constant

If the price of bonds is above the equilibrium​ price, there occurs an excess

supply of bonds, the price of bonds will fall, and the interest rate will rise.

theory of portfolio choice

tells us how much of an asset people will want to hold in their portfolios (p133)

opportunity cost

the amount of interest (expected return) sacrificed by not holding the alternative asset- in this case a bond

Using the liquidity preference​ framework, when the economy​ expands:

the demand for money will​ increase, shifting the money demand curve to the right

when a yield curve slopes upward...

the long-term interest rates are more profitable than short-term interest rates

how does the reduced liquidity of corporate bonds affect their interest rates relative to the interest rate on Treasury bonds?

the lower liquidity of corporate bonds relative to treasury bonds increases the spread between the interest rates on these two bonds

market equilibrium

the point at which the quantity supplied equals the quantity demanded

When the wealth of individuals decreases

the price of bonds decreases while the interest rates increase

risk structure of interest rates

the relationship among interest rates on bonds that have different characteristics but the *same* maturity

term structure of interest rates

the relationship among interest rates on bonds with different terms to maturity

wealth

the total resources owned by the individual, including all assets

Fisher effect

when expected inflation rises, interest rates will rise

excess supply

when the quantity of bonds supplied exceeds the quantity of bonds demanded

default-free bonds

will always be repaid eg: US treasury bonds, because the federal government can always increase taxes or print money to pay off its obligations

Will there be an effect on interest rates if brokerage commissions on stocks​ fall? A. ​Yes, interest rates would rise because stocks become more liquid than​ before, which would reduce the demand for bonds B. ​Yes, interest rates would fall because stocks would have a relatively higher rate of return than​ bonds, which would reduce the demand for bonds C. ​No, interest rates would remain the same because the brokerage commissions would only affect the stock market D. ​Yes, interest rates would rise because people would want to hold more stocks and fewer​ bonds, which would increase the demand for bonds

​A. Yes, interest rates would rise because stocks become more liquid than​ before, which would reduce the demand for bonds

Would fiscal policy makers ever have reason to worry about potentially inflationary​ conditions?

​Yes, higher inflation leads to a higher debt service burden and increases the costs of financing deficit spending.

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?

​Yes, the decrease in investment opportunities and known risk factors significantly offset the wealth effect on demand and the deficit effect on supply.

If the demand for bonds shifts to the​ left, the price of bonds

​decreases, and interest rates rise.