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Chapter 5: Q.10 (page 164)

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?

Short Answer

Expert verified

Bond prices will rise, lowering interest rates, as supply and interest rates have an indirect relationship.

Step by step solution

01

Introduction

The amount demanded of an asset is directly related to wealth, expected return on asset, and liquidity of the asset, and negatively proportional to expected return on alternative asset, liquidity of the alternative asset, according to the theory of portfolio choice.

02

Ste[p 2: Explanation

If large corporations decide not to issue bonds, the supply curve for bonds will shift to the left, indicating a decrease in supply. As a result of the reduced supply, bond prices will rise, lowering interest rates, as supply and interest rates have an indirect relationship.

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Most popular questions from this chapter

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

Go to the St. Louis Federal Reserve FRED database, and find data on the M1money supply (M1SL) and the 10-year U.S. Treasury bond rate (GS10). For the M1money supply indicator, adjust the units setting to “Percent Change from Year Ago,” and for both variables, adjust the frequency setting to “Quarterly.” Download the data into a spreadsheet.

a. Create a scatter plot, with money growth on the horizontal axis and the 10-year Treasury rate on the vertical axis, from 2000:Q1to the most recent quarter of data available. On the scatter plot, graph a fitted (regression) line of the data (there are several ways to do this; however, one particular chart layout has this option built in). Based on the fitted line, are the data consistent with the liquidity effect? Briefly explain.

b. Repeat part (a), but this time compare the contemporaneous money growth rate with the interest rate four quarters later. For example, create a scatter plot comparing money growth from 2000:Q1with the interest rate from 2000:Q1, and so on, up to the most recent pairwise data available. Compare your results to those obtained in part (a), and interpret the liquidity effect as it relates to the income, price-level, and expected-inflation effects.

c. Repeat part (a) again, except this time compare the contemporaneous money growth rate with the interest rate eight quarters later. For example, create a scatter plot comparing money growth from 2000:Q1with the interest rate from 2002:Q1, and so on, up to the most recent pairwise data available. Assuming the liquidity and other effects are fully incorporated into the bond market after two years, what do your results imply about the overall effect of money growth on interest rates?

d. Based on your answers to parts (a) through (c), how do the actual data on money growth and interest rates compare to the three scenarios presented in Figure 11of this chapter?

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? Discuss the possible resulting situations.

Using both the liquidity preference framework and the supply and demand for bonds framework, show why interest rates are procyclical (rising when the economy is expanding and falling during recessions)

Would fiscal policymakers ever have reason to worry about potentially inflationary conditions? Why or why not?
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