Professor Cunningham. 1. Question 7 on p. 127 of Mishkin. Liquidity Preference

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1 Money and ankng FE434, Sprng 02 rofessor Cunnngham roblem Set 2 Solutons 1. Queston 7 on p. 127 of Mshkn. Lqudty reference Durng a boom n the cycle, ndvdual s tend to ncrease ther spendng (consumpton). Ths means they requre lqud assets n order to fund ther spendng. The money demand curve shfts left, mplyng a hgher equlbrum nterest rate (from 0 to 1 ): M s 1 0 M d M d M ond Market Smlarly, durng a boom ncome ncreases. If ths ncome s saved, and some of the savngs s n the form of bonds, the bond demand curve shfts rght ( d to d ). Frms also ncrease ther borrowng n order to fnance expanson. Ths causes bond supply to shft rght ( s to s ) as well. We know from the chapter that the demand effect tends to be smaller than the supply effect, leadng to lower equlbrum prces ( 0 to 1 ) and hgher nterest rates ( 0 to 1 ): s 0 0 s 1 1 d d

2 Money and ankng FE434, Sprng 02 rofessor Cunnngham roblem Set 2 Solutons 2. Currently, the U. S. Congress and resdent are consderng sgnfcant spendng ncreases for a varety of programs (ncludng but not lmted to natonal defense). There are two fscal polcy optons avalable, assumng these expendtures are non-negotable. The frst (lan A) entals an ncrease n spendng wthout a change n tax polcy, whle the second (lan ) entals an ncrease n spendng wth a slowdown n the tax cuts whch were enacted last year. a. Use a bond market graph to portray the mpact of lan A on the equlbrum rce, Quantty, and yeld of U. S. Treasures. The supply of Treasures ncreases snce those Treasures are used to fnance the new spendng by the government (tax revenues are fallng). There wll be an ncrease n demand f some of the new spendng by the government s saved, but we wll not assume ths s the case. Result: s 0 s 0 1 d The equlbrum quantty of bonds ncreases, the nterest rate drops, and the prce falls as well (the new equlbrum has a 1 subscrpt, the old equlbrum has a 0 subscrpt). b. Use a bond market graph to portray the mpact of lan on the equlbrum rce, Quantty, and yeld of U. S. Treasures. In ths case, the Treasury need not ssue as many new bonds n order to fnance the ncreased expendtures (the bond supply curve only shfts to s ) snce tax revenues are not fallng as much as under lan A. Thus, we have the followng graph: s 0 2 s s d

3 Money and ankng FE434, Sprng 02 rofessor Cunnngham roblem Set 2 Solutons Thus, at the new equlbrum prces stll fall, nterest rates stll rse, and total bonds n the Treasury market ncrease. However, the effect on the market s less pronounced under lan (the values for the lan equlbrum have a 2 subscrpt). c. Use two bond market graphs (one for lan A, one for lan ) to portray the mpact of these optons on the market for corporate debt. lan A s d d 1 The effect of lan A on the corporate debt market s shown above. Snce Treasures are offerng a hgher yeld, the demand for corporate debt declnes. Ths drves down the prce of corporate debt and ncreases the yeld (movng from the equlbrum wth the 0 subscrpt to the equlbrum wth the 1 subscrpt). lan s d d 1 d Under ths plan, the yeld on Treasures does not rse as much as under lan. Ths mples that the drop n demand for corporate bonds s

4 Money and ankng FE434, Sprng 02 rofessor Cunnngham roblem Set 2 Solutons lower (to d rather than d ). Thus, prce drops by less and yelds ncrease by less (to the values wth the 2 subscrpt). d. Contrast the mpact of each plan on the market for U. S. Treasures and corporate debt. Whch plan mght be preferred by ssuers of corporate debt? 3. Queston 7 on p. 149 of Mshkn. a. Clearly, ssuers of corporate debt prefer lan, wheren yelds on corporate debt do not rse as much (to 2 rather than 1 ); under ths plan the cost of ssung debt does not rse as much as under lan A. Yeld Maturty The current yelds on bonds of maturty 1, 2, 3, 4, and 5, whch are mpled by ths path of 1-year nterest rates are, respectvely, 5, 5.5, 6, 6, 5.8.

5 Money and ankng FE434, Sprng 02 rofessor Cunnngham roblem Set 2 Solutons b Yeld Maturty The current yelds on bonds of maturty 1, 2, 3, 4, and 5, whch are mpled by ths path of 1-year nterest rates are, respectvely, 5, 4.5, 4, 4, Suppose that bond market yelds at maturtes of 1, 2, 3, 4 and 5 years are 4, 6, 10, 11, and 15. Under the expectatons theory of the yeld curve, what are the expected yelds on one year bonds n the future? If you beleve the bond market (and the expectatons theory) should you borrow now or n the future? The expected yelds are 1t = 4, e 1t+1 = 8, e 1t+2 = 18, e 1t+3 = 14, e 1t+4 = 31. It s better to borrow now, snce nterest rates are expected to rse.

6 Money and ankng FE434, Sprng 02 rofessor Cunnngham roblem Set 2 Solutons 5. Suppose that securtes n Tanzana are offerng nterest rates of 40%. The currency n Tanzana s the Shllng. In addton, suppose that securtes n Europe offer an nterest rate of 8%. Fnally, the future expected exchange rate of Shllngs per Euro s 875 (E e t+1). Suppose you are a European. a. Create a well-labeled nterest party condton graph from ths nformaton. E sh / 875 RET RET sh E *.08.4 b. Solve for the equlbrum current nterest rate. From the nterest party condton, we have:.08 =.4 [(875 E*)/ E*]. Solvng for E*, we fnd a current equlbrum exchange rate of 662. Ths mples that the Euro s expected n apprecate n ths confguraton. c. Suppose nflaton falls n Tanzana. What wll happen to the nterest rate assocated wth Tanzana securtes (you may use a bond market graph here)? The bond demand curve wll shft rght (hgher demand due to a hgher real return on bonds) whle the supply curve wll shft left (lower supply due to a hgher real cost of ssung bonds). Ths leads to a hgher equlbrum prce and a lower equlbrum yeld to maturty,. e. nterest rates drop (the Fsher effect).

7 Money and ankng FE434, Sprng 02 rofessor Cunnngham roblem Set 2 Solutons d. Use the nterest party graph to dsplay the effect of the change n Tanzanan nflaton on the equlbrum Shllng / Euro exchange rate. Does the Shllng deprecate or apprecate? Snce nterest rates n Tanzana are droppng, holdng everythng else constant, the return on shllng-denomnated assets n Tanzana s lower. The RET sh curve shfts left (to RET sh ), as shown below. Ths means the current equlbrum exchange rate s hgher at E (the Tanzana currency loses some of ts value whle the Euro gans n value). E sh / 875 E E * RET RET sh RET sh.08.4