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Chapter 5: Q.23 (page 165)

Using both the supply and demand for bonds and liquidity preference frameworks, show how interest rates are affected when the riskiness of bonds rises. Are the results the same in the two frameworks?

Short Answer

Expert verified

Interest rates rise as bond risk increases, and both the liquidity preference framework and the supply and demand framework of bonds give the same result.

Step by step solution

01

Introduction

A bond is a financial instrument issued by an entity in exchange for a return on the bond. These are utilised to fund the company's activities. The bond's return might be either fixed or variable.

02

Explanation

When the risk associated with the bond rises, the demand bond falls, causing the demand curve to move to the left. The bond price falls and the interest rate rises as a result of the leftward movement. In the liquidity framework, the bond's high riskiness in comparison to money raises demand for money and shifts the demand curve rightward, raising the interest rate.

When a result, interest rates rise as bond risk increases, and both the liquidity preference framework and the supply and demand framework of bonds produce the same conclusion.

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Most popular questions from this chapter

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

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?

M1 money growth in the U.S. was about 15%in localid="1647014587488" 2011and2012, and 10%in 2013. Over the same time period, the yield on 3-month Treasury bills was close to 0%. Given these high rates of money growth, why did interest rates stay so low, rather than increase? What does this say about the income, price-level, and expected-inflation effects

The president of the United States 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.

One of the points made in this chapter is that inflation erodes investment returns. Go to http://www.moneychimp.com/articles/econ/inflation_calculator.htm and review how changes in inflation alter your real return using the second inflation calculator. What happens to the difference between the future value of an investment and its inflation-adjusted value as

a. inflation increases?

b. the investment horizon lengthens?

c. expected returns increase?
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