Economics 330 (Kelly)

Spring 2001
Answers to Practice Questions #1

Disclaimers:
(1) We are not responsible for errors or inconsistencies in these answers.
(2) These answers may be neither comprehensive nor complete, i.e., they are not necessarily
sufficient exam answers. They are intended only to be a guide for your potential responses.

True/False/Uncertain:
 
1) Bond demand
a) TRUE: in a business cycle expansion, with growing wealth, the demand for bonds rises and
the demand curve for bonds shifts to the right. In a recession, when income and wealth are
falling, the demand for bonds falls, i.e., the demand curve shifts to the left. How much
demand shifts either in an expansion or in a recession depends on the elasticity of demand.
b) FALSE: Higher interest rates in the future lower the expected return for long-term bonds
(due to expected capital losses) and therefore decrease the demand for bonds at each interest
rate, i.e., the demand curve shifts to the left. Conversely, lower expected interest rates in the
future increase the current demand for bonds, i.e., shifts the demand curve to the right.
c) FALSE: An increase in the expected rate of inflation lowers the expected return for bonds
and therefore causes their demand to decrease, i.e., their demand curve shifts to the left.
d) FALSE: If prices of bonds become more volatile, i.e., there is an increase in the risk of
bonds, bonds as assets become less attractive and therefore their demand falls, i.e., their
demand curve shifts to the left. Conversely a decrease in the risk of bonds increases their
demand.
e) TRUE: An increase in liquidity makes bonds easier to sell and therefore, other things equal,
will cause an increase in the demand for bonds at every interest rate, i.e., their demand curve
shifts to the right. Similarly, increases in the liquidity of alternative assets, other things
equal, will lower the demand for bonds.
2) Bond supply
a) TRUE: In a recession, when there are fewer expected profitable investment opportunities,
the supply of bonds falls, i.e., the supply curve shifts to the left. Conversely, in a business
cycle expansion, the supply of bonds will increase with the increased amount of good
investment opportunities.
b) TRUE: If the government deficit decreases, the excess of government expenditures over its
income is less and so the government’s financial needs in the form of new bond placements
decreases.
3) Interest rates
a) FALSE: Using the liquidity preference framework, it is easy to see that an increase in
income will raise the demand for money, and given a fixed money supply, interest rates will
rise. That is, in a business cycle expansion when income is rising, interest rates will rise.
b) FALSE: The demand for money is the demand for a real stock and therefore, given a
constant money supply, an increase in the price level will reduce the real quantity of money
causing people to increase their demand for nominal balances in order to restore the real

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 value of their stock of money. This increase in the demand for nominal money will produce
an increase in interest rates.
c) TRUE: An increase in the money supply, other things constant, will imply a decrease in the
interest rates, since in order for the economic agents to hold this increased amount of money,
the return of alternative assets (in this case the interest rate of bonds) has to decrease.
d) UNCERTAIN: As a result of an increase in the rate of growth of money supply, there will
be four effects: (a) an income effect which has the effect of increasing interest rates in the
long run; (b) a price level effect which has the effect of increasing interest rates in the long
run; (c) an expected inflation effect, which has the effect of increasing interest rates in the
long run and (d) (see question 10), a liquidity effect, which in the short run, decreases
interest rates. Therefore, depending on the magnitude of the liquidity effect compared to the
magnitude of the other three effects combined, we have three possible outcomes, an increase
in the interest rates, no change in the interest rates or a decrease in the interest rates (in the
long run).
4) FALSE: If the real interest rate increases, people have the incentive to increase their future
consumption, i.e. to increase their demand for bonds today and to decrease their current
consumption.
5) TRUE: As was already pointed out in question 12, an increase in the real interest rate implies an
increase in the demand for bonds today since people has the incentive to save more today to
increase their future consumption.
6) Bonds
a) TRUE: Prices and returns for long-term bonds are more volatile than those for shorter-term
bonds. Investments in long-term bonds are quite risky due, among other things, to interest
rate risk.
b) FALSE: The interest rate of a bond is generally thought as the yield-to-maturity for that
bond. The return of a bond takes into consideration the possibility of holding the bond for a
period that is different than the whole maturity period of the bond and therefore possible
changes in the price of the bond have to be taken into consideration when calculating the
return of that bond. In other words the return of the bond not only includes the interest rate
earned in the bond but also the possible capital gains or losses due to differences in the
buying and selling prices.
c) FALSE: The current yield only equals the yield to maturity when the bond price is at par.
Both are concepts of interest rates, however.
d) FALSE: See number 15, which is the same question.
e) TRUE: For discount bonds and zero-coupon bonds that make no intermediate cash payments
before the holding period is out, the price at the end of the holding period is already fixed at
the face value. Changes in interest rates, then can have no effect on the price at the end of
the holding period, and the return will therefore be equal to the yield to maturity known at
the time the bond is purchased.
f) TRUE: The discount yield has as one of its terms the difference between the face value and
purchase price of the discount bond. Because the purchase price necessarily decreases
relative to the face value as the maturity increases, the percentage gain on the face value
necessarily becomes a worse approximation to the percentage gain on the purchase price as
the maturity increases.

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7) FALSE: This depends on how you diversify. Constructing a portfolio with a beta of 2.0, for
instance, increases your risk. More generally, if assets are highly positively correlated,
diversification does little or no good to the risk-averse investor.
8) FALSE: Borrowing money through a financial intermediary does entail payment of fees,
however the funds may not be available as readily or at suitable terms through other financial
channels. Without financial intermediaries there would be less borrowing, hence less
investment and capital formation.
 
Other Questions:
 
1) A number of responses are possible. One consideration is that the higher the interest rate, the
higher the opportunity cost of money – an individual would want to stay as fully invested as
possible, while still having enough liquid assets to cover expenses.
2) The longer the maturity, the greater the price risk. The longer the maturity, the lower the
reinvestment risk.
3) No, to the extent that U.S. individuals and corporations are subject to income taxes. One wants
to look at the after-tax real rate.
4) No difference – the interest rate (yield to maturity) of a consol is the coupon payment divided by
the price of the consol. This is precisely the current yield on the consol.
5) Two benefits: (1) interest and principal are not eroded by inflation, and (2) they generate direct
information on expected inflation (via subtracting the nominal rate). A cost is that the bonds are
not indexed for taxation – when the interest and principal increase, the bearer’s tax payments
also increase.
6) When the coupon bond is priced at its face value, the yield to maturity equals the coupon rate.
7) The price of a coupon bond and the yield to maturity are negatively related.
8) Initially, the real interest rate is (5-2)=3%, but the expected real rate in the future is (10-9)=1%.
The real cost of borrowing is expected to decrease… borrowing should increase.
9) Income and the price level cause the demand curve for money to shift in Keynes’ liquidity
preference analysis. Income: as an economy expands and income rises, wealth increases and
people will want to hold more money as a store of value; also, people will want to carry out
more transactions using money, with the result that they will also want to hold more money.
Price level: when the price level rises, the same nominal quantity of money is no longer as
valuable; to restore their holdings of money in real terms to its former level, people will want to
hold a greater nominal quantity of money.
10) Liquidity effect: an increase in the money supply, ceteris paribus, lowers the interest rates.
Basically, supply goes up, so the price of money goes down. Income effect: an increase in the
money supply is expansionary, so raises both national income and wealth, which leads to higher
interest rates. Price-level effect: an increase in the money supply is inflationary, which leads to
an increase in the interest rate. Expected-inflation effect: the rising price level also affects the
expected inflation rate… people see higher prices and expect continuing inflation. This results
in an increase in the interest rate.
11) Equity share vs. real-estate share
a) In a word, yes.
b) Most corporate equity is held by the wealthiest 10% of the population. More than half of all
households hold no corporate equity. SCF data show that the Flow of Funds statistics are
characteristics of a household at the 95th percentile of the wealth distribution. A large

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 majority of households own real estate, which comprises approximately two-thirds of their
total assets.
c) Indirect equity ownership through retirement plans and mutual funds is growing at between
18 and 25% per annum since 1989. Direct equity holdings growing at approximately 13%
p.a. since 1989. The bull market.
d) It should steadily decrease after age 20, but it doesn’t. It remains roughly constant for
individuals aged 20-40, as these individuals keep moving into bigger and more expensive
homes.
e) Probable cause: houses are indivisible. Attendant risks: non-diversified portfolio, coupled
with high leverage; asset value positively correlated with regional economy (i.e., negative
shocks positively correlated). Possible remedies: metropolitan house price indexes, and
“housing partnerships”.
12) US$
a) Around 70% of the U.S. currency is outside of the U.S., mostly because of its stability. See
the reading packet article for a detailed explanation.
b) If demand for currency is becoming driven largely by foreign portfolio decisions, then
fluctuations in the level of currency outstanding may have little to do with domestic
economic activity. Movements in the narrow monetary aggregates will not provide the same
information as they have historically. To the extent that foreigners demand currency, which
is non-interest-bearing debt, the U.S. Treasury’s need to issue an interest-bearing alternative
is reduced (seignorage).
13) See the textbook for a thorough discussion.
14) Money
a) For this question, consider the extent to which certain assets (e.g., equities) are taking on the
theoretical properties of “money”. Ask whether a monetary aggregate like M1 accurately
measures the amount of money in the U.S. Keep in mind that, generally speaking, “money
is what money does”.
b) Yes, it’s called seignorage, or the “inflation tax”.
15) EMOPs
a) Payors may benefit through increased control of the timing of payments and the receipt of
funds, more accurate record keeping, and potentially lower costs. Accounting costs may be
reduced for both the payor and payee by tracking invoices and payments electronically.
b) Security issues, capital costs (i.e., computers, modems, card readers), and the fact that
checks serve as receipts (which most people like).
16) EMU
a) No independent monetary policy, no competitive devaluation, constrained fiscal policies.
b) Reduced transaction costs, no exchange-rate uncertainty, no competitive devaluations, no
speculative attacks.
c) Answers will vary.
17) Size allows them to diversify their asset holdings. Size allows them to support research
departments that specialize in evaluating information about expected returns and about the
riskiness of specific loans. Owners of intermediaries are predominately stockholders who
assume risk in exchange for high expected returns.