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Chapter 5: Q.8 (page 164)

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?

Short Answer

Expert verified

The attribute that will be impacted by the government's choice is liquidity.

Step by step solution

01

Introduction

Liquidity is defined as the ease with which an asset or security can be turned into money and vice versa. Because it has the power to influence product demand, liquidity is one of the most important features of an asset.

02

Explanation

If the government places limits on the number of daily transactions that can be made in the bond market, the bond's liquidity will be reduced. If the bond's liquidity is reduced, demand for the bond falls, lowering the bond's price.

Bond demand will fall as investors prefer more liquid assets to less liquid assets, and as the bond market becomes more constrained, investors will seek for more liquid security. The attribute that will be impacted by the government's choice is liquidity.

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Most popular questions from this chapter

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?

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

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?

Go to the St. Louis Federal Reserve FRED database, and find data on net worth of households and nonprofits (HNONWRQ027S) and the 10-year U.S. Treasury bond (GS10). For the net worth indicator, adjust the units setting to “Percent Change from Year Ago,” and for the 10-year bond, adjust the frequency setting to “Quarterly.”

a. What is the percent change in net worth over the most recent year of data available? All else being equal, what do you expect should happen to the price and yield on the 10-year Treasury bond? Why?

b. What is the change in yield on the 10-year Treasury bond over the last year of data available? Is this result consistent with your answer to part (a)? Briefly explain.

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)
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