EXAM 2 HW QUESTIONS

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

The steeply upward sloping yield curve in the figure above indicates that ________ interest rates are expected to ________ in the future. A) short-term; rise B) short-term; fall moderately C) short-term; remain unchanged D) long-term; fall moderately

A

Will a U.S. Treasury bill have a risk premium that is higher​ than, lower​ than, or the same as that of a similar security​ (in terms of maturity and​ liquidity) issued by the government of​ Colombia?

A U.S. Treasury bill will have a lower risk premium since U.S. government issued securities are usually considered to be default free.

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.

Risk premiums on corporate bonds are usually anticyclical​; that​ is, they decrease during business cycle expansions and increase during recessions. Why is this​ so?

As the economy enters an​ expansion, there is greater likelihood that borrowers will be able to service their debt.

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. .

The following three characteristics of a bond are collectively embedded in the risk structure of interest rates except A. income tax treatment. B. liquidity. C. risk of default. D. difference in maturity.

D.difference in maturity.

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.

Which of the following would cause the risk premium on corporate bonds to fall​? A. There are fewer participants in the bond marketsThere are fewer participants in the bond markets causing a reduction in the daily volume of causing a reduction in the daily volume of transactions.transactions. B. There is an increase in brokerage commissions. C. U.S. Treasury bonds become more liquid. D. Forecasters predict that the economy will grow more quickly for the next few years.

Forecasters predict that the economy will grow more quickly for the next few years.

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.

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, 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 pure expectations theory.

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

Increase

Prior to​ 2008, mortgage lenders required a house inspection to assess its​ value, and often used the same one or two inspection companies in the same geographical market. Following the collapse of the housing market in​ 2008, mortgage lenders required a house​ inspection, but this was arranged through a third party. How does this illustrate a conflict of interest similar to the role that​ credit-rating agencies played in the global financial​ crisis?

Inspection companies may have provided overly optimistic assessments of home values to ensure continued work in the future.

Which of the following statements is true​? A. Yield curves almost always slope downward. B. When short minus term interest rates are low comma yield curves tend to be inverted. C. Interest rates on bonds of different maturities tend to move together over time. D. When​ short-term interest rates are​ high, yield curves tend to be upward sloping.

Interest rates on bonds of different maturities tend to move together over time.

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?

Interest rates on corporate bonds will decrease

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.

What effect would reducing income tax rates have on the interest rates of municipal​ bonds?

Interest rates would rise because the reduction in income tax rates would make the​ tax-exempt privilege for municipal bonds less valuable and reduce the demand for municipal bonds.

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 does it mean when the yield curve is flat?

It means that short and long term interest rates are the same.

If junk bonds are​ "junk," then why would investors buy​ them?

Junk bonds can provide high yields.

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.

Predict what would happen to the risk premium on corporate bonds if brokerage commissions were lowered in the corporate bond market.

Lower brokerage commissions for corporate bonds would make them more liquid and thus increase their demand, which would lower their risk premium.

Do you think that it will then make sense for municipal bonds to be exempt from income​ taxes?

No. If this were to​ happen, then municipal bonds will be even better than U.S. government bonds.

What would happen to the risk premiums of municipal bonds if the federal government guarantees today that it will pay creditors if municipal governments default on their payments.

Risk premium on municipal bonds will decrease.

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.

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.

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.

During​ 2008, the difference in yield​ (the yield spread​) between​ 3-month AA-rated financial commercial paper and​ 3-month AA-rated nonfinancial commercial paper steadily increased from its usual level of close to​ zero, spiking to over a full percentage point at its peak in October 2008. Which of the following explains this sudden​ increase?

The increase in the yield spread was a result of the decrease in demand for financial commercial paper due to the uncertainty and soundness of financial companies and banks.

What effect would reducing income tax rates have on the interest rates of municipal bonds? Would interest rates of Treasury securities be affected, and, if so, how?

The reduction in income tax rates would make the tax-exempt privilege for municipal bonds less valuable, and they would be less desirable than taxable Treasury bonds. The resulting decline in the demand for municipal bonds and increase in demand for Treasury bonds would raise interest rates on municipal bonds while causing interest rates on Treasury bonds to fall.

In 2010 and​ 2011, the government of Greece risked defaulting on its debt due to a severe budget crisis. Using bond market​ graphs, determine how default would affect the risk premium between U.S. Treasury debt and Greek debt with comparable maturity.

The risk premium would​ increase, which corresponds to segment B on the graphs above.

if the expectations of future short-term interest rates suddenly fell, what would happen to the slope of the yield curve?

The slope of the yield curve would fall

How would your yield curves change if people preferred shorter-term bonds over longer-term bonds?

The upward-sloping yield curve in (a) would be even steeper if people preferred short-term bonds over long-term bonds because long-term bonds would then have a positive risk premium. The downward-sloping yield curve in (b) would be less steep and might even have a slight positive upward slope if the long-term bonds have a positive risk premium.

In the fall of​ 2008, AIG, the largest insurance company in the world at the​ time, was at risk of defaulting due to the severity of the global financial crisis. As a​ result, the U.S. government stepped in to support AIG with large capital injections and an ownership stake. How would this​ affect, if at​ all, the yield and risk premium on AIG corporate​ debt?

The yield and risk premium will fall since demand for AIG corporate debt will increase.

If expectations of future​ short-term interest rates suddenly​ fall, what would happen to the slope of the yield​ curve?

The yield curve would become flatter

How would your yield curve change if people preferred​ shorter-term bonds over​ longer-term bonds?

The yield curve would become steeper.

Following a policy meeting on March​ 19, 2009, the Federal Reserve made an announcement that it would purchase up to​ $300 billion of​ longer-term Treasury securities over the following six months. What effect might this policy have on the yield​ curve?

The yield curve would shift​ down, but mostly on​ medium- and​ long-term maturities.

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.

Just before the collapse of the subprime mortgage market in​ 2007, the most important​ credit-rating agencies rated​ mortgage-backed securities with Aaa and AAA ratings.Explain how it was possible that a few months into​ 2008, the same securities had the lowest possible ratings.

When housing prices began to fall and subprime mortgages began to​ default, many​ AAA-rated products had to be downgraded over and over again.

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.

If the yield curve suddenly becomes​ steeper, how would you revise your predictions of interest rates in the​ future?

You would raise your predictions of future interest rates.

Will you advise borrowing short or long​ term?

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

A plot of the yields on bonds with different terms to maturity but the same​ risk, liquidity, and tax considerations is known as

a yield curve.

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

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

Given the market activity shown in the diagrams​ above, the risk premium is _________ Based on this​ information, it is more likely that the economy is entering an _________

decreasing, expansion

suppose you observe a change in the relationship between​ short-term and​ long-term bonds.​ Specifically, you note that although interest rates on both​ short-term and​ long-term bond are rising​ together, as​ expected, the rate on​ long-term bonds is not rising by as much as has been observed in the past. Assuming the liquidity premium theory of term​ structure, you conclude that the liquidity premium is _________ As a​ result, the yield curve becomes ____________

decreasing, flatter

if people expect inflation

demand for $$$ will increase (ppl want money now to buy things now). In turn, market Interest Rate will increase (bond price decreases)

when short term interest rate is high, curve is

downward sloping

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

fall

If a yield curve looks like the one shown in the figure below, what is the market predicting about the movement of future short-term interest rates? What might the yield curve indicate about the market's predictions for the inflation rate in the future?

fall moderately in the future but increase later on

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.

According to the liquidity premium and preferred habitat theories of the term structure of interest​ rates, a flat yield curve indicates that

future​ short-term interest rates are expected to fall.

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.

If the income tax exemption on municipal bonds were​ abolished, the interest rates on these bonds would

increase

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.

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

A decrease in the price level causes

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

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

If a yield curve looks like the one shown in the figure below, what is the market predicting about the movement of future short-term interest rates? What might the yield curve indicate about the market's predictions for the inflation rate in the future?

rise moderately in the near future but fall later on.

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

If a yield curve looks like the one shown in the diagram to the​ right, what is the market predicting about the movement of future​ short-term interest​ rates? inflation?

short-term interest rates will increase in the near term, then decrease in the long term . inflation will increase in the near term, then decrease in the long term .

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.

The spread between the interest rate on a​ one-year U.S. Treasury bond and a​ 20-year U.S. Treasury bond is known as the

term premium

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

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

When the Fed increases the money supply

the interest rate falls and this stimulates investment spending

When the wealth of individuals decreases

the price of bonds decreases while the interest rates increase

If the risk premium on corporate bonds​ increases, then

the spread between the interest rate on corporate bonds and the interest rate on​ default-free bonds has become greater.

According to the segmented markets theory of the term structure of interest​ rates, if bondholders prefer​ short-term bonds to​ long-term bonds, the yield curve will be _______

upward sloping

when short term interest rate is low, yield curve is

upward sloping

expectations theory cannot explain why

yield curve is usually upward sloping

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 interest rates of Treasury securities be affected by the tax rate​ change?

​Yes, because the reduction in the​ tax-exempt privilege in municipal bonds would raise the relative value of Treasury​ securities, making Treasury securities more desirable.

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.