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Page1 Test your understanding of course material for Midterm 1 The number of questions on each chapter included here are no indication of the weight to that chapter on the exam 1. Would you be willing to give up your checkbook and instead use an electronic means of payment if it were made available? Why or why not. Not necessarily. Checks have the advantage in that they are easier to keep track of, and may also make it harder for someone to steal money out of your account. These advantages of checks may explain why the movement toward a checkless society has been very gradual. 2. For each of the following assets indicate which of the following monetary aggregates (M1 or M2) includes them: a) Currency b) Money market time deposits c) Small-denomination time deposits d) Checkable deposits (a) M1 and M2, (b) M2, (c) M2, (d) M1 and M2 In questions 3-8 categorize the transactions described according to whether they (a) rely on financial markets or intermediaries, (b) occur in primary or secondary market, or (c) are carried out in money or capital markets. 3) A bank makes a 30-year mortgage loan to a household 4) A bank sells a mortgage loan to a government sponsored financial intermediary 6) Joan Robinson sells her shares of ABC stock to someone else 7) The DEF money market mutual fund buys $100,000 of 3-month Treasury bills in the government’s weekly auction 8) DEF bus $100,000 of 3-month Treasury bills from First bank 3. The transaction (a) takes place through a financial intermediary, (b) is in a primary market, and (c) is in a capital market. 4. The transaction (a) takes place through a financial intermediary, (b) is in a secondary market, (c) is in a capital market. 6. The transaction (a) takes place in a financial market, (b) is in a secondary market, (c) is in a capital market. 7. The transaction (a) takes place through a financial intermediary, (b) is in a primary market, and (c) is in a money market. 8. The transaction (a) takes place through a financial intermediary, (b) is in a secondary market, and (c) is in a money market 9. Typically, you will receive a very low interest rate on money you deposit in a bank. Interest rates on car loans and business loans are much higher. Why, then, do most people prefer putting their money in a bank to lending it directly to individuals or businesses?

Page1 Putting your money in a bank increases your liquidity, decreases your risk, and decreases your information cost. Directly lending your funds to someone for a car or business loan, decreases your liquidity (your money would be tied up in the loans), increases your risk (the loans may default), and increases your cost of determining whether the loans would be paid off. Depositing your funds in a bank allows you to withdraw your money when needed, transfers the risk of default to the bank, and eliminates your need to evaluate the loans. 10. Suppose financial intermediaries did not exist and only direct finance were possible. How would this affect the process of an individual buying a car or a house? Direct finance would make the process of an individual buying a car or a house much more difficult. The car or house buyer would either have to accumulate the savings to pay for the car or house, or find someone willing to directly lend them the funds. Direct finance, as opposed to indirect finance through financial intermediaries, incurs more risk, less liquidity, and more information costs. These drawbacks would increase the interest rate that the lender charges and reduce the number of loans. 11. Discuss whether your money, wealth, or income increases in each of the following situations: a. The value of your house increases. b. Your boss gives you a 10% raise. c. You take cash out of the bank and use it to buy an Apple iPad. a. Wealth increases b. Income increases c. The value of your money falls once you have spent the cash. The form you are holding your wealth in changes from cash to an iPad, but the value of your wealth does not change. 12. On January 1, 2002, Germany officially adopted the euro as its currency, and the deutsche mark stopped being legal tender. According to an article in the Wall Street Journal, even 10 years later many Germans continued using the deutsche mark, and many stores in Germany continued to accept it. Briefly explain how it is possible for people to continue to use a currency when the government that issued it has replaced it with another currency. As long as many German stores continued to accept the deutsche mark, it could serve as money. As the example of the Russian taxi drivers using Marlboro cigarettes as money showed, anything that is generally accepted as a mean of payment can serve as money. 13. Suppose that an economy in 10,000 B.C. used a rare stone as its money. Suppose also that the number of stones declined over time as stones were accidentally destroyed or used as weapons. What would have happened to the value of the stones over time? What would the consequences likely have been if someone had discovered a large quantity of new stones? When the stones are destroyed, the value of stones increases because there are fewer of them relative to goods and services. As a result, prices are likely to fall and the economy will experience deflation. When someone finds a new quantity of stones, the value of stones falls because there are more of them relative to goods and services. As a result, prices are likely to rise and the economy will experience inflation. 14. One historian has given the following description of the economy of the Roman Empire in the third century under the emperor Diocletian: The coinage had become so debased as to be virtually worthless. Diocletian’s attempt to reissue good gold and silver coins failed because there simply was not enough gold and silver available to restore confidence in the currency. Diocletian finally accepted the ruin of the money economy and revised the tax system so that it was based on payments in kind. The soldiers too came to be paid in kind. a. What does it mean to say that the coinage had become debased?

Page1 b. Why would government officials need to restore confidence in the coins before people would use them as money? c. What are “in kind” payments? How might moving from a system of payments being made in gold and silver coins to a system of payments being made in kind affect the economy of the empire? a. The coinage had greater amounts of less valuable metals mixed in with the gold and silver. b. Money is only as good as the confidence a person has in its value. Citizens need to trust that the money the government is creating has value and will be accepted by others. c. “In kind” means to pay for a service or good with another service or good. Paying in kind would increase the cost of trade and other economic activity, thereby and decrease specialization and the level of income in the empire. 15. Suppose that debit cards, ATMs, ACH transactions, and other forms of electronic funds transfers did not exist. How would this change the way you shop and pay bills? How would transactions costs in the economy affected? Households would rely more on cash and personal checks to buy goods and services and to pay bills, and would need to make more stops at banks to deposit checks and withdraw cash. The transactions costs of shopping and buying goods would increase, which would result in lower incomes. 16. In late 2009, Amazon introduced PayPhrase, an electronic payments system intended to compete with PayPal. Less than three years later, in early 2012, Amazon discontinued the program. PayPal is by far the largest electronic payments system. What problems might competitors encounter in trying to set up a competing system? Competitors to PayPal would need to have enough merchants and households using their electronic payments system to make the system work and would need enough business to spread the overhead costs of setting up the competing electronic payments system. Economists use the phrase “network externalities” when referring to the lower costs that a firm like PayPal has relative to potential entrants to its market. The more merchants and households that use PayPal, the more desirable using the system becomes for other merchants and households, the lower PayPal’s cost are, and the more difficult it becomes for new entrants to compete with it. 17. Why aren’t credit cards included in M1 or M2? Credit is not a form of money, because it is a debt that is owed to the issuer of the card. A transaction using a credit card is completed only when the credit card debt is paid off—typically using a check. 18. Why might households and firms in a foreign country prefer to use U.S. dollars rather than their own country’s currency in making transactions? What advantages or disadvantages do foreign governments experience because of the U.S. dollar being used rather than the domestic currency? Some countries with less central bank discipline have inflation problems or currency crises. Holding U.S. dollars is a way for households and firms to avoid the losses cause by inflation reducing the purchasing power of the domestic currency. Also, many goods traded internationally are purchased in dollars, so it is convenient to hold dollars. The key advantage to foreign governments of households and firms using the U.S. dollar is that doing so avoids the loss of economic efficiency and income that would result from their economies reverting to barter. In addition, if the governments lack the political will to gain control over their money supplies, using U.S. dollars is a way of avoiding severe inflation. The disadvantages to the foreign governments include the inability to conduct monetary policy, which requires the central bank to be able to control the money supply.

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Page1 19 . When financial markets channel funds from savers to investors, who benefits? Explain. With a well-functioning financial system, both parties to the transaction benefit when funds are channeled from savers to investors. Investors are able to con- duct projects that generate profits and savers are able to earn a positive return on their funds by gaining access to some of these profits. The benefits of well-functioning financial markets go beyond the gains that accrue to the immediately involved parties—here, the savers and investors. Since financial markets aid in the realization of new investment projects—for example, the building of new factories—workers and consumers also gain. The true benefit of financial markets lies in their supporting role in fostering economic growth as measured by real GDP. 20. Suppose an owner of a corporation needs $1 million to finance a new investment. If his total wealth is $1.2 million, would it be better to use his own funds for the investment or to issue stock in the corporation? What if the owner’s wealth is $1 billion? The principle of diversification suggests that the owner of the corporation will have a stronger interest in financing the new investment through issuing stock when his wealth is lower. The owner with the $1.2 million wealth would have to put all of his or her eggs into one basket if the investment were financed using only their own funds. With the larger wealth, a number of projects can be financed with his or her funds and diversification will take place without any stock issued. 21 . Suppose a company raises funds by issuing short-term bonds (commercial paper). It uses the funds to make private loans. Such a firm is called a finance company . Is a finance company a type of bank? No, a finance company is not a type of bank. Banks are defined as financial institutions that take in deposits and make loans. Finance companies raise funds not from deposits, but by issuing commercial paper. Like banks, finance companies make loans, but their source of funds is different from those of a bank. 22 . Firms such as Moody’s and Standard & Poor’s study corporations that issue bonds. They publish “ratings” for the bonds—evaluations of the likelihood of default. Suppose these rating companies went out of business. What effect would this have on the bond market? What effect would it have on banks? Published bond ratings are a tool to overcome the problem of asymmetric information in financial markets in which savers and investors have a direct relationship. Reducing the problem of asymmetric information between savers and investors leads to a more effective channeling of funds to productive uses through financial markets. If the rating companies went out of business, overcoming asymmetric information problems would be more costly for savers and reduce the volume of transactions in financial markets. Banks should benefit from this development. Financial intermediaries, such as banks, are an alternative tool to overcome asymmetric information problems. More savers will rely on banks after the ratings companies go out of business. The recent financial crisis in the United States has shown that it is not enough to have credit rating agencies, but that these agencies also need to have the right incentives in order to provide accurate—and not overly optimistic—ratings. 23. Suppose that technology completely eliminates the use of cash. People buy newspapers by putting debit cards in the newspaper box. They use the Internet to pay babysitters. With no cash, does the nature of money change? Should the Federal Reserve change the definition of M1? M1 is one measure of a monetary aggregate, summing mostly the amount of currency and checking deposits (traveler’s checks are already negligible and will go the way of dinosaurs in the near future). If the use of cash were completely eliminated, M1 would still be meaningful because the use of debit cards and the Internet ultimately affects people’s checking account deposits when payments are made. Your use of the debit card to buy a newspaper triggers an immediate deduction from your checking account balance, so does the use of the Internet to pay a babysitter. In order to have a readily available medium of exchange in a cashless society, checking ac- count deposits would still have to be held. The Federal Reserve does not need to change the definition of M1. Currency would simply enter as zero.

Page1 24. Explain how each of these events affects the amount of M1 that people hold. (i) ATMs are invented. The ATM (automatic teller machine) now gives you 24-hour access to your checking account, whereas before you had to go to a live person in a bank branch during regular business hours to make a withdrawal. This will probably change the amount of cash you carry in your wallet. There is no need for large cash balances in your wallet if you can always get to an ATM to replenish your cash, as long as you have checking deposits. But since both cash and checking deposits are part of M1, the total amount of M1 should not be affected when ATMs give you access to your checking account. If the ATM also gives you access to your savings account, you may start to keep more deposits in the savings account (to earn a bit more interest) because you could make regular ATM withdrawals from your savings deposits if necessary. This decision will reduce the amount of M1 because lower balances are held in checking deposits and higher balances are held in savings deposits. (Note that M2 will not be affected by this decision.) (ii) Credit cards are invented. Using a credit card to make a purchase means that you borrow until you pay off the credit card bill. You will have to transfer checking deposits to your credit card company to pay your credit card bill. Instead of accessing your checking de- posit each time you make a purchase, you know that you need your checking de- posit at only one time each month, when you pay your credit card bill. If you keep most of your money in a savings account until you have to pay your credit card bill, only transferring the necessary funds into checking deposits when necessary, your aver- age monthly balance in checking deposits will be lower compared to a situation in which you do not have a credit card. This decision will reduce the amount of M1. (iii) Debit cards are invented. The use of debit cards for payment means that your checking deposit is reduced each time you make a purchase. Contrary to using a credit card, you are not able to put off reducing your checking account deposits until you pay one, larger bill. Thus, the introduction of debit cards should not change M1. (iv) Stored-value cards are invented. A stored-value card can be thought of as a prepaid debit card. In that sense, the stored-value card becomes an alternative to holding checking deposits. Like checking deposits, the stored-value card gives you access to very liquid assets that are available as a medium of exchange. Since stored-value cards are not counted as part of M1, the invention of these cards will reduce M1 as people shift checking account deposits to the stored-value cards. (v) Interest rates on bonds rise. If interest rates on bonds rise, it becomes more costly to hold cash and checking deposits, both of which are assets that are generally non-interest-bearing. With a higher interest rate, people have an incentive to manage their liquid, non- interest-bearing assets more closely so that more assets can be held as bonds. Thus, a higher interest rate should reduce average cash and checking deposit balances and reduce M1. 25. State and local governments typically offer their employees defined benefit pension plans. Under these plans, employees are promised a fixed monthly payment after they retire. A government’s pension liability is the amount that it has committed to paying future retirees. An article in the Economist magazine notes that as interest rates fall, “the present value of future liabilities rises.” a. What does the author mean by the “present value of future liabilities”? b. Why would a decline in interest rates increase the present value of a government’s future pension liabilities? Source: “Keeping It Real,” Economist, June 30, 2012. a.The “present value of future liabilities” means the present value of the future fixed stream of benefit payments the government must make to retired workers. b. A decline in interest rates increases the present value of any future stream of payments, including, in this case, the payments the government must make to people receiving pensions. With lower interest rates, the government would need more funds today to be able to invest and generate the future fixed stream of pension benefit payments. 26. Why do consumers usually prefer fixed-payment loans to simple loans when buying cars and houses?

Page1 Fixed-payment loans are popular with households because as long as the household makes all the payments, the loan will be completely paid off. There will be no large final payment for the household to worry about as with a simple loan where the whole principal is due, along with the interest, in a lump-sum payment when the loan matures. Given the high prices of cars and houses, most consumers would like to avoid having to make a single lump-sum payment to pay off the loan they had taken out to buy one of these goods. 27. True/False. Explain If the price of a coupon bond with face value $1000 is currently $1100 and you hold the bond until maturity then YTM > the current yield. False because there is an implicit capital loss when P > F => YTM < current yield 28. Suppose that in exchange for allowing a road to pass through his farmland, George Pequod has been paid $135 per year by the township he lives in. He had been promised this payment in perpetuity. Now however, the township has offered and he has accepted, a one-time payment of $1125, in exchange for giving up the right to receive the annual $135 payment. What implicit interest rate have George and the township used in arriving at this settlement? In effect, the payments to George were like those of a perpetuity or consol. Therefore, the relevant interest rate would be $135/$1125 = 12%. 29. What is the break even rate? What does it reflect? It is the difference in yield on a nominal and inflation-protected bond of equivalent maturity. It reflects the average annualized expected inflation rate for the duration of the maturity period. 30. What are the costs and benefits of the presence of the TIPS market? Read the discussion in the article “How TIPS works” and other WSJ articles posted on Bb. 31. January 1, 2002 you bought a coupon bond for $1102. You received a coupon of $50 on December 30 . On January 1, 2003, you sold the bond for $989. What was your total rate of return? Show your work. C/P + [P - P ]/P = 50/1102 +[989 - 1102]/1102 = 0.0454 – 0.1025 = -0.0575 = -5.75% 32. What is the yield to maturity on a $1,000 face/par value discount bond maturing in 1 year that sells for 800? 25% = ($1,000 - $800)/$800 = $200/$800 = 0.25. 33. If there is a decline in interest rates, which would you rather be holding, long-term bonds or short-term bonds? Why? You would rather be holding long-term bonds because their price would increase more than the price of the short-term bonds, giving them a higher return 34. In early 2010, newspapers reported that NBA superstar Kobe Bryant had signed an extension to his existing contract. His salaries in future years under the contract extension would be as follows:  For the season ending in 2012: $25,244,000  For the season ending in 2013: $27,849,000  For the season ending in 2014: $30,453,000 For simplicity, assume that the salary for the season ending in 2012 (2013) [2014] would be received in a lump sum two (three) [four] years from when Kobe Bryant signed the contract. Newspapers reported that the contract extension had a value of $85 million. Let i = 2%. Were they correct? Answer: Consider a low interest rate of 2%. The present value of the extension is:

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Page1 No, the newspaper was not correct because it did not take into account the time value of money. 35. A student asks: If a coupon bond has a face value of $1,000, I don’t understand why anyone who owns the bond would sell it for less than $1,000. After all, if the owner holds the bond to maturity, the owner knows he or she will receive $1,000, so why sell for less? Answer the student’s question. The price of a bond will be below its face value of $1,000 only if the bond has a coupon rate below the coupon rates on newly issued bonds. For example, a bond with a coupon rate of 3% will see its price fall below $1,000 if similar, newly issued bonds have coupon rates of 5%. Although the owner of the bond with the 3% coupon rate will still receive a payment of the bond’s $1,000 face value if he or she holds the bond to maturity, it may be a number of years before the bond matures. During the years before the bond matures, the owner will be receiving $20 less per year than he or she would receive from owning a newly issued bond. As a result, should the owner of the bond decide to sell the bond, he or she would be willing to accept a price below $1,000. 36. Briefly explain whether you agree with the following statement: If interest rates rise, bonds become more attractive to investors, so bond prices will rise. Therefore, when interest rates rise, bond prices will also rise. Disagree. The statement is confusing newly issued bonds with existing bonds. Investors like to receive higher interest rates when they buy newly issued bonds. But investors suffer losses if they hold existing bonds when interest rates on newly issued bonds rise. The key point is that bonds offer a fixed stream of future payments, and an increase in market interest rates decreases the present value of that stream of future payments, causing the prices of existing bonds to fall. 37 . Ford Motor Company has issued bonds with a maturity date of November 1, 2046, that have a coupon rate of 7.40%, and it has issued coupon bonds with a maturity of February 15, 2047, that have a coupon rate of 9.80%. Why would Ford issue bonds with coupons of $74 and then a little more than a year later issue bonds with coupons of $98? Why didn’t the company continue to issue bonds with the lower coupon? Either conditions in the bond market changed with long-term market interest rates rising, or investors became more reluctant to buy Ford’s bonds, perhaps because they believed that Ford’s risk of defaulting on its bonds had increased. In either case, investors were requiring a higher interest rate to invest in Ford’s bonds, so Ford would not have been able to sell bonds with a 7.4% coupon rate. 38. Consider the following analysis: The rise and fall of a bond’s price has a direct inverse relationship to its yield to maturity, or interest rate. As prices go up, the yield declines and vice versa. For example, a $1,000 bond might carry a stated annual yield, known as the coupon of 8%, meaning that it pays $80 a year to the bondholder. If that bond was bought for $870, the actual yield to maturity would be 9.2% ($80 annual interest on $870 of principal). Do you agree with this analysis? Briefly explain. The analysis is partially correct. There is an inverse relationship between bond prices and bond yields, and the rate of return on the coupon payment is higher if the purchase price is lower. However, the analysis incorrectly uses the current yield (the value of the coupon expressed as a percentage of the current price) as the yield to maturity 39. S uppose you are about to borrow $15,000 for four years to buy a new car. Briefly explain which of these situations you would prefer to be in: i) The interest rate on your loan is 10%, and you expect the annual inflation over the next four years to average 8%. ii) The interest rate on your loan is 6%, and you expect the annual inflation rate over the next four years to average 2%. You would prefer option (i). The interest rate of 10% with and expected inflation rate of 8% would be preferred because the expected real interest rate is lower.

Page1 40. When will the real interest rate differ from the expected real interest rate? Would this possible difference be of more concern to you if you were considering making a loan to be paid back in 1 year or a loan to be paid back in 10 years? The difference between the real interest rate and the expected real interest rate exists because the future inflation rate is unknown, causing the actual inflation rate to often differ from the expected inflation rate. This possible difference would be more of a concern for a 10-year loan than for a 1-year loan because the actual inflation rate could differ more from the expected inflation rate for a 10-year period than a 1-year period. In particular, if the inflation rate were to be persistently higher over the 10-year period than you had expected when you made the loan, you would be receiving a lower than expected real interest rate during the 10 years. 41. An article in the New York Times notes that “rising bond yields can … signal the threat of inflation.” Briefly explain why, if investors expect inflation to be higher, the yields on bonds will rise. Source: Nelson D. Schwartz, “Surprise Increase in Rates Is Credited to Signs of Recovery,” New York Times, March 18, 2012 An increase in expected inflation raises nominal interest rates and yields on bonds. Investors require higher nominal interest rates to compensate for the higher expected decline in the real purchasing power of the bond payments. Unless bond yields rise when inflation rises, bond investors will suffer falling real interest rates. 42. Separate Trading of Registered Interest and Principal of Securities (STRIPS) take a bond with n years to maturity and convert it into discount bonds. Briefly explain how this is done. What would be the maturity dates of these discount bonds? A coupon bond pays semi-annual or annual coupon payments and at maturity the bond holder receives the face value. Each of these nominal payments are known. So, you can take each coupon payment and make it into a discount bond. E.g.: suppose the coupon payment = $80. Consider the payment that is due 2 years from now. I can sell this coupon payment as a discount bond. This specific discount bond has a maturity date of 2 years, the face value on the bond would be $80, and it would be sold for a price less than $80. You would do this for each coupon payment and the face value of the original coupon bond. The maturity date on the discount bonds will vary from the date of the next coupon payment to the maturity date of the coupon bond. 43. Suppose that your marginal federal income tax rate is 30%, the sum of your marginal state and local tax rates is 5%, and the yield on a thirty-year corporate bond is 10%. You would be indifferent between buying this corporate bond and buying a thirty-year municipal bond (ignoring differences in liquidity, risk, and costs of information) if the municipal bond has a yield of (a) 6.5%. (b) 7.0%. (c) 9.5%. (d) 10.0%. (e) none of the above 0.3(10) + 0.05(10) = 3.5 => 10-3.5 = 6.5. 44. Suppose that your wealth elasticity of demand for Google stock is 2, you own 1000 shares of Google and your total wealth is $1 million. You earn a $100,000 bonus at work. How much more Google stock will you buy? Your increase in holdings will be 2(10%) = 20%. You will buy 0.2(1000) = 200 shares. 45. Suppose that you are an investor with a choice of 3 assets that are identical in every way except their return and taxability. Which asset yields the highest after-tax return? Asset 1: Interest rate 10%, interest taxed at 40% Asset 2: Interest rate 8%, interest taxed at 25% Asset 3: Interest rate 6.5%, no tax on interest Asset 1 yields 6% after taxes; asset 2 yie lds 6%; asset 3 offers the highest return, yielding 6.5%. 46. Suppose that you are investing money in a portfolio of stocks and are choosing from among Badrisk Company, which returns 30% in good years and loses 50% in bad years: Worserisk Company which returns 30%

Page1 in good years and loses 75% in bad years; Norisk Company which returns 10% all the time and Lowrisk which returns 20% in good years and loses 5% in bad years. a) If you were completely risk averse and your only goal was to minimize your risk, which stocks would you buy? b) If you were risk neutral in good years and good and bad years occurred half the time, which stocks would you buy? c) If you were somewhat risk-averse, would you ever have both Badrisk and Worserisk In your portfolio? Why or why not? (a) You would buy Norisk only. (b) You would buy Norisk only because it has the highest average expected return of 10%. (c) No; Worserisk is dominated by Badrisk; it offers the same return in good times but a lower return in bad times. 47. What is the present value of a bond that pays $340 one year from now and $5340 2 years from now at a constant interest rate of 6.8%? The present value is $5000 (  340/1.068 + 5340/(1.068) 2 ). 48. Suppose that you have just bought a 4-year $10,000 coupon bond with a coupon rate of 7% when the market rate of interest is 7%. Immediately after you buy the bond the market interest rate falls to 5%. What happens to the value of your bond? At an initial interest rate of 7%, the bond’s price equals face value since c =7%. At an interest rate of 5%, the bond’s value is 700/1.05 + 700/1.05 2 + 700/1.05 3 +700/1.05 4 + 10,000/1.05 4 = 666.67 + 634.92 + 604.69 + 575.89 + 8227.02 = $10,709.19. Hence the bond’s value rises as the yield falls. 49. Suppose that you are considering the purchase of a coupon bond that has the following future payments: $600 in one year, $600 in 2 years, $600 in three years, and $600 + $10,000 in four years. a) What is the bond worth today if the market interest rate is 6%? What is the bond’s current yield? b) Suppose that you have just purchased the bond and suddenly the market interest rate falls to 5% for the foreseeable future. What is the bond’s worth now? What is the current yield now? c) Suppose that one year has elapsed, you have received the first coupon payment of $600 and the market interest rate is still 5%. How much would another investor be willing to pay for the bond? If another investor had bought the bond a year ago for the amount you calculated in (b) what would that investor’s total return have been? d) Suppose 2 years have elapsed since you bought the bond and you have received the first 2 coupon payments of $600 each. Now suppose that the market interest rate suddenly jumps to 10%. How much would another investor be willing to pay for your bond? What will the bond’s current yield be over the next year? Suppose that another investor had bought the bond at the price you calculated in (c). What would that investor’s total return have been over the past years? (a) Value = $10,000; current yield = 600/10,000 = 6%. (b) Value = 600/1.05 + 600/1.05 2 + 600/1.05 3 + 10,600/1.05 4 = $10,354.60; current yield = 600/ 10,354.60 = 5.79%. (c) Value = 600/1.05 + 600/1.05 2 + 10,600/1.05 3 = $10,272.33 ; yield = (600 + 272.33)/10,000 = 8.72%; total rate of return a year ago = [600 + (10,272.33 – 10,354.60)]/10,354.60 = 5%.

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Page1 (d) Value = 600/1.10 + 10,600/1.10 2 = $9,305.78; current yield over the next year = 600/9305.78 = 6.45%; total return based on price calculated in (c) = [600 + (9305.78 – 10,272.33 )]/10,272.33 = –3.57%. 50. Calculate the present value of a $ 1,000 discount bond with five years to maturity if the yield to maturity is 6%. PV  FV /(1  i ) n , where FV  1000, i  0.06, n  5. Thus, PV  747.26. 51. If the current price in the bond market is above the equilibrium price, explain how the bond market adjusts to equilibrium. The excess supply of bonds causes the price of bonds to fall, increasing the quantity demanded and decreasing the quantity supplied. Neither the demand curve nor the supply curve will shift. 52. Many economists assume that a boom in stock prices is a sign that profitable business opportunities are expected in the future. Use a demand and supply graph for bonds to show the effect of a boom in stock prices on the equilibrium interest rate. The profitable business opportunities would shift the supply curve to the right from S 1 to S 2 . The increase in stock prices would reduce the expected return on bonds relative to stocks, causing the demand curve for bonds to shift to the left from D 1 to D 2 . As shown in the graph below, the price of bonds would fall, but the equilibrium quantity might either, rise, fall, or remain unchanged, depending on the relative sizes of the shifts in the demand and supply curves. 53. Writing in the Wall Street Journal, economists Jeremy Siegel and Jeremy Schwartz made the following prediction: “We believe that when investors awake from their depressed state, they will realize that they don’t have to lend the U.S. government money for 10 years at a negative real yield.” a. By “negative real yield” did Siegel and Schwartz mean that the nominal interest rate on 10-year Treasury notes was negative? Briefly explain. b. In 2012, why were investors willing to accept a negative real yield on 10-year Treasury notes? Source: Jeremy J. Siegel and Jeremy Schwartz, “The Bond Bubble and the Case for Stocks,” Wall Street Journal, August 22, 2012. a. Siegel and Schwartz did not mean that the nominal interest rate on 10-year Treasury notes was negative, but instead that the real interest rate was negative. That is, that the nominal interest rate was less than the inflation rate. b. Federal Reserve monetary policy in response to the financial crisis of 2007 – 2009 had pushed other interest rates to low levels and investors were concerned about risk following that financial crisis. Because Treasury notes are free of default risk, investors were willing to buy them even at very low nominal interest rates. 54 . How will the bond market adjust to an increase in the expected inflation rate? Use a demand and supply graph for bonds to illustrate your answer.

Page1 According to the Fisher effect, the nominal interest rate rises or falls point for point with changes in the expected inflation rate. An increase in the expected inflation rate causes the demand curve to shift to the left from D 1 to D 2 , and the supply curve to shift to the right from S 1 to S 2 . As a result, the price of bonds falls and the interest rate on bonds rises. This graph shows the Fisher effect working exactly, with the change in the expected inflation rate leaving the quantity of bonds unchanged: 55 . I n 2012, an article in the Economist magazine recommended to investors that if economic growth and infl- ation remained low in the United States, the investors should buy bonds. But if inflation accelerated rapidly, investors should “buy commodities, especially gold.” a. Why would bonds be a good investment in a period of low growth and low inflation? b. Why would bonds be a poor investment in a period of high inflation? Source: “Ben Buys, Bulls Buoyant,” Economist, September 22, 2012. a. Low growth and low inflation can lead to lower nominal interest rates and higher bond prices. Higher bond prices result in capital gains for owners of existing bonds. A stronger economic expansion and an increase in inflation will lead to higher nominal interest rates, pushing bond prices down and causing capital losses for owners of existing bonds. b. High inflation causes nominal interest rates to rise, pushing bond prices down and causing capital losses for owners of existing bonds. 56. An article in the New York Times in 2012 observed: Older Americans and other savers are just unintended casualties of policies aimed at other economic targets, particularly the policy making it easier for consumers and companies to borrow. a. What policies have made it easier for consumers and companies to borrow? b. How have these policies made casualties of older Americans and other savers? Why would older Americans in particular be casualties? Source: Catherine Rampell, “As Low Rates Depress Savers, Governments Reap Benefits,” New York Times, September 10, 2012. a. Federal Reserve policies to stimulate the economy through lower short-term and long-term interest rates have made it easier for consumers and companies to borrow. b. These Federal Reserve policies have decreased the interest return on banks certificates of deposit (CDs) and other types of saving that older Americans particularly rely on for a significant portion of their incomes. 57. How would the following events affect the demand for loanable funds in the United States? a. Many U.S. cities increase business taxes to help close their budget deficits. b. Widespread use of tablet computers helps reduce business costs. c. The government eliminates the tax deduction for interest that homeowners pay on mortgage loans. a. After-tax expected profitability falls, so the demand for loanable funds decreases. b. Expected profitability rises, so the demand for loanable funds increases. c. The increase in the return to saving decreases the supply loanable funds. 58. An article in the Economist magazine in 2012 observed: “America can now borrow from the bond market at a cheaper rate than at any time in the history of the republic.” Use the loanable funds model to analyze how this statement could be true even though the United States was running a large budget deficit in 2012. Source: “To Strive, to Seek, to Find, and Not to Yield,” Economist, June 30, 2012 T he large budget deficit shifted the demand curve for loanable funds to the right, but increased household saving resulting from higher expected future taxes shifted the supply curve for loanable funds to the right. Additionally, both foreign and domestic investors placed loanable funds in the Treasury market due to low interest rates on other financial assets and the continued concern about risk following the financial crisis. The increased supply of loanable funds kept interest rates from rising.

Page1 59. We have seen that Federal Reserve Chairman Ben Bernanke has argued that low interest rates in the United States during the mid-2000s were due to a global savings glut rather than to Federal Reserve policy. In an interview with Albert Hunt of Bloomberg Television, Alan Greenspan, who was Federal Reserve Chairman from August 1987 through January 2006, made a similar argument. Greenspan argued: Behind the low level of long- term rates: A global savings glut as China, Russia and other emerging market economies earned more money on exports than they could easily invest. a. Use two loanable funds graphs to illustrate Greenspan’s argument that a global savings glut caused low interest rates in the United States. One graph should illustrate the situation in the United States, and the other graph should illustrate the situation in the rest of the world. b. Why should a debate over the cause of low interest rates matter to Alan Greenspan? Source: Rich Miller and Josh Zumbrun, “Greenspan Takes Issue with Yellen on Fed’s Role in House Bubble,” Bloomberg. com, March 27, 2010. a . In the graph that follows, begin with the world real interest rate equal to 3% and the rest of the world as a net international lender and the United States as a net international borrower. An increase in saving in the rest of the world shifts the supply curve for loanable funds in the rest of the world to the right, lowering the world real interest rate to 1%. With the increased saving, the rest of the world increases its international lending, and with the lower world real interest rate, the United States increases its international borrowing. a) b) There is a debate over whether the Federal Reserve during Alan Greenspan’s term as chairman was responsible for low interest rates or whether the global savings glut was responsible. If the global savings glut was responsible, we could argue that the Federal Reserve and Greenspan should take less blame for the low interest rates that helped facilitate the housing bubble. 60. Suppose that businesses in Japan reduce their spending on plant and equipment. What will be the effect on spending on plant and equipment by businesses in the United States? Because Japan is a large open economy, the decrease in the demand for loanable funds in Japan will lower the world real interest rate. At a lower real interest rate, businesses in the United States will increase their spending on plant and equipment. Note that this answer ignores the potentially offsetting effect operating through the impact of lower spending on plant and equipment in Japan on Japanese national income and on Japanese demand for goods and services produced in the US 61 . Suppose that individuals in the US expect that inflation will rise in the future. Use bond markets to explain how this increase in expected inflation will affect nominal interest rates in the US. Graphically illustrate your answer.

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Page1 Fisher equation: r = i - π e . A rise in expected inflation will lead to a fall in the real interest rate. Demand for bonds will fall since bond holders will get a lower real return. The supply of bonds will rise, since the real cost of borrowing has now decreased. Bond prices will fall ⇒ interest rates will increase. 62. In the spring of 1999 it was unclear whether the Norwegian economy was expanding or whether it would fall into a deeper recession in the future. If it began to expand, then inflation was likely to increase. If it fell into a deeper recession, then government borrowing was likely to increase. Use relevant graphs to explain the impact on interest rates assuming Norway is a closed economy. What if Norway is an open economy? (Assume that Norway is initially neither lender nor borrower in the international market). An increase in expected inflation(π e ): Fisher equation: r = i – π e A rise in expected inflation will lead to a fall in the real interest rate. Demand for bonds will fall since bond holders will get a lower real return. The supply of bonds will rise, since the real cost of borrowing has now decreased. Bond prices will fall ⇒ interest rates will increase. Bond Market Loanable funds market Price Interest rate Q B Q L Increased government borrowing: The increased government borrowing would increase the supply of bonds. Bond prices would fall and interest rates will increase. Bond Market Loanable funds market Price Interest rate Q B Q L

Page1 When governments (federal, state or local) expenditures exceed revenues, it borrows to fill the deficit by selling bonds. When the government runs a deficit, households may look ahead and conclude that at some point the government will have to raise taxes to pay off the bonds issued to finance the deficit. To prepare for those future higher tax payments, households may begin to increase their saving. This increased saving will shift the demand curve for bonds to the right at the same time that the supply curve for bonds shifts to the right because of the deficit. This second effect is smaller than the first so that the net effect will be a rise in interest rate and a fall in bond prices If Norway is an open economy, it is small in relation to the global economy => the real rate of interest that will prevail in Norway would be the world rate of interest. Changes in Norway’s demand and supply for loanable funds would make Norway either a net borrower or lender at any prevailing world rate of interest. Norway will become a borrower in international markets if supply of bonds increases (=demand for loanable funds increases) at any given world rate of interest. 63. 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, B d , shifts to the left and the equilibrium interest rate rises. 64. Suppose you go to a bank, intending to buy a certificate of deposit with your savings. Explain why you would not offer a loan to the next individual who applies for a car loan at your local bank at a higher interest rate than the bank pays on certificates of deposit (but lower than the rate the bank charges for car loans). During your visit at the bank you will probably realize that you will receive an annual interest rate of 1% or 2% if you buy a certificate of deposit, while an individual asking for a car loan will be required to pay an annual interest rate of 7% or 8%. At the beginning, it seems tempting for you to offer an interest rate of 4%, which would make both of you better off. However, you would probably like to know that individual better, in particular his net worth (to assess his ability to pay you back), or his credit history (has he or she defaulted on a loan before?). This process will probably be time consuming and costly for you. Even if you decide to engage in this transaction anyway, you will probably want to write a contract to be able to recover your money if this individual does not pay you back. As before, this will be costly. Your local bank is much more efficient in dealing with the adverse selection and moral hazard problems created by asymmetric information, so much so that you are better off by buying a certificate of deposit and avoiding all the transaction costs associated with making a loan. 65 . What is the yield to maturity on a simple loan for $ 1 million that requires a repayment of $ 2 million in five years’ time? 14.9%, derived as follows: The present value of the $2 million payment five years from now is $2/(1 + i ) 5 million, which equals the $1 million loan. Thus 1 = 2/(1 + i ) 5 . Solving for i , (1 + i ) 5 = 2, so that 66) Explain why the nominal interest rate is the opportunity cost of holding money. Opportunity cost is what you have to forgo to engage in an activity. When nominal interest rates rise on financial assets, the amount of interest that households and firms lose, or forgo, by holding money increases. When nominal interest rates fall on financial assets, the amount of interest that households and firms lose, or forgo, by holding money decreases. 67) Explain what happens to the nominal interest rate when the Fed decreases the money supply. Make

Page1 use of a graph of the money market to illustrate this change in the money supply and the nominal interest rate. When the Fed decreases the money supply, the money supply curve shifts to the left. This decreases the equilibrium quantity of money and increases the equilibrium nominal interest rate. 68) Explain what happens to the nominal interest rate when there is an increase in real GDP. Make use of a graph of the money market to illustrate this change in real GDP and the nominal interest rate. When there is an increase in real GDP, the money demand curve shifts to the right. This increases the equilibrium nominal interest rate.

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