Ch. 6

Which of the following factors would be most likely to lead to an increase in nominal interest rates? A. Households reduce their consumption and increase their savings. B. A new technology like the internet has just been introduced, and it increases investment opportunities. C. There is a decrease in expected inflation. D. The economy falls into a recession. E. The Federal Reserve decides to try to stimulate the economy.

A. Households reduce their consumption and increase their savings.

Assume that the current corporate bond yield curve is upward sloping. Under this condition then we could be sure that... A. Inflation is expected to decline in the future. B. The economy is not in a recession. C. Long-term bonds are a better buy than short-term bonds. D. Maturity risk premiums could help to explain the yield curves upward slope. E. Long-term interest rates are more volatile than short-term rates.

D. Maturity risk premiums could help to explain the yield curves upward slope.

During periods when inflation is increasing, interest rates tend to increase, while interest rates tend to fall when inflation is declining. True or false?

True

If the pure expectations theory is correct, a downward sloping yield curve indicates that interest rates are expected to decline in the future. True or false?

True

•The yield curve is...

a graph of the term structure. •The May 2018 Treasury yield curve is shown at the right.

•Term structure:

relationship between interest rates (or yields) and maturities.

Constructing the Yield Curve: Inflation •Step 1:

•Step 1: Find the average expected inflation rate over Years 1 to N

Determinants of Interest Rates: •r = •r = •r* = •IP = •DRP = •LP = •MRP =

•r = r* + IP + DRP + LP + MRP •r = required return on a debt security •r* = real risk-free rate of interest •IP = inflation premium •DRP = default risk premium •LP = liquidity premium •MRP = maturity risk premium

"Nominal" vs. "Real" Rates: •r = •r* = •r(sub)RF =

•r = represents any nominal rate •r* = represents the "real" risk-free rate of interest. Like a T-bill rate, if there was no inflation. Typically ranges from 1% to 4% per year. •r(sub)RF = represents the rate of interest on Treasury securities.