Download Econ 201 Intermediate Macroeconomics

Econ 201 Intermediate Macroeconomics
Assignment 2 - Solution
(Chapter 14, 15)
1. Label each of the following statement true, false, or uncertain. Explain briefly.
a) The real interest rate is equal to the nominal interest rate divided by the price level.
FALSE.
b) The price of one-year bond increases when the nominal one year interest rate
increases.
FALSE.
c) The value today of a nominal payment in the future cannot be greater than the
nominal payment itself.
TRUE. Nominal interest rates cannot be negative, but real interest rates can.
d) Worries about future inflation would tend to make the yield curve slope down.
FALSE. Future short-term nominal interests are expected to increase. So the yield
curve should be upward sloping.
e) An equal increases in expected inflation and nominal interest rate at all maturities
should lead to a fall in stock prices.
FALSE.
f) A rational investor should never pay a positive price for a stock that will never
pay dividends.
FALSE. Rational Speculative Bubble.
2. Question 3 of Chapter 14 in the textbook.
a.
No. If the nominal interest rate were negative, nobody would hold bonds.
Money would be more appealing since it could be used for transactions and
would earn zero — as opposed to negative — interest.
b.
Yes. The real interest rate is negative if expected inflation exceeds the
nominal interest rate. Even in this case, the real interest rate on bonds (which
pay nominal interest) exceeds the real interest rate on money (which does not
pay nominal interest) by the nominal interest rate.
c.
A negative real interest rate makes borrowing very attractive and leads to a
large demand for investment.
d.
Answers will vary.
3. Question 8 of Chapter 14 in the textbook.
a. The IS shifts right. At the same nominal interest rate, the real interest rate is lower,
so output is higher.
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b. The LM shifts right.
c. Output increases. The nominal interest rate is higher than in Figure 14-5. Whether
the nominal interest rate is lower or higher than before the increase in money growth
is ambiguous. Thinking in terms of the money market equilibrium, the increase in
the nominal money supply tends to reduce the nominal interest rate, but the increase
in nominal money demand (because of the increase in output) tends to increase the
nominal interest rate.
d. Output is higher than in Figure 14-5. Reasoning from the IS relation, the real
interest rate must be lower, since no exogenous variables in the IS relation have
changed. (In other words, while the nominal interest rate may increase relative to
Figure 14-5, it increases by less than the increase in expected inflation. So the real
interest rate decreases.)
4. Question 2 of Chapter 15 in the textbook.
$F
2000
a. $ P =
⇒ 1700 =
⇒ i = 4.15%
n
(1 + i )
(1 + i ) 4
2000
b. 1700 =
⇒ i = 3.30%
(1 + i ) 5
2000
c. 1750 =
⇒ i = 2.71%
(1 + i ) 5
5. Suppose the yield curve is initially upward sloping. Use your knowledge of the IS-LM
model and the yield curve to explain what effect each of the following events will have
on the shape of the yield curve.
a) Financial markets expect a future reduction in consumer confidence which results
in a reduction in consumer spending.
A reduction in consumer spending will cause the IS curve to shift left and the interest
rate to fall. The expected future one-year rate will fall causing the yield curve to
become flatter.
b) Financial markets expect a future Fed monetary expansion.
A monetary expansion will cause the LM curve to shift right. The expected future
one-year rate will fall causing the yield curve to become flatter.
c) Financial markets expect a future reduction in government spending which is
accompanied by a Fed monetary expansion.
A reduction in government spending will shift the IS curve to the left and a monetary
expansion will shift the LM curve to the right. The expected future one-year rate will
fall causing the yield curve to become flatter.
d) Financial markets expect a future tax cut.
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A tax cut will shift the IS curve to the right due to the increase in the disposable
income of consumer. The expected future one-year rate will increase causing the
yield curve to become steeper.
6. Question 8 of Chapter 15 in the textbook.
a.
The Fed can reduce the growth rate of money. The nominal interest rate
increases in the short run, but falls in the medium run.
b.
Inflation was highest in early 1980. The 12-month inflation rate peaked at
14.6% in March and April of 1980.
c.
(graph)
d.
A positive spread means that expected future interest rates are higher than
current interest rates. A declining spread means that the expected increase in
future short-term interest rates is falling. The one-year T-bill rate increased
from 7.28% to 12.6% between January 1978 and January 1980, but the spread
declined from 0.9 percentage points to –1.46 percentage points over the same
period. Financial market participants were not expecting short-term interest
rates to continue to increase. Indeed, by the end of the 1970s, the negative
spread indicates that short-term interest rates were expected to decline in the
future.
e.
There spread declined by almost one percentage point in October 1979. The
decline is consistent with expectations of lower inflation in the future.
f.
The one-year interest rate fell.
g.
During the rate cut in the recession, spreads went up, as short-term rates
declined. However, long-term rates did not increase, which suggests that
inflation expectations did not increase. Instead, the increase in spreads is
consistent with the expectation that the anti-inflationary policy would
continue with high short-term interest rates after the recession. This is indeed
what happened.
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7.
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