Download Demand for bonds - Iowa State University Department of Economics

IOWA STATE UNIVERSITY
Department of Economics
Spring 2003
Economics 353: Section 2
Money, Banking and Financial Institutions
ANSWER KEY FOR VERSION A
PART ONE: Multiple-Choice Questions (Total 40 points: 1 point each)
1) Evidence from the United States and other foreign countries indicates that
A) there is a strong positive association between inflation and growth rate of money over long
periods of time.
B) there is little support for the assertion that "inflation is always and everywhere a monetary
phenomenon."
C) countries with low monetary growth rates tend to experience higher rates of inflation, all
else being constant.
D) money growth is clearly unrelated to inflation.
Answer: A
2) Prior to recessions in this century, there has been a drop in
A) inflation.
B) the money stock.
C) the growth rate of the money stock.
D) interest rates.
Answer: C
3) The bond markets are important because
A) they are easily the most widely followed financial markets in the United States.
B) they are the markets where foreign exchange rates are determined.
C) they are the markets where interest rates are determined.
D) of each of the above.
E) of only (a) and (b) of the above.
Answer: C
4) The price of one country's currency in terms of another's is called
A) the exchange rate.
B) the interest rate.
C) the Dow Jones industrial average.
D) none of the above.
Answer: A
5) Which of the following is most likely to result from a stronger dollar?
A) U.S. goods exported aboard will cost less in foreign countries, and so foreigners will buy
more of them.
B) U.S. goods exported aboard will cost more in foreign countries and so foreigners will buy
more of them.
C) U.S. goods exported abroad will cost more in foreign countries, and so foreigners will buy
fewer of them.
D) Americans will purchase fewer foreign goods.
Answer: C
6) Which of the following are true statements?
A) Those countries with the highest inflation rates are also the ones with the highest money
growth rates.
B) The average price of goods and services in an economy is called the inflation rate.
C) When the average price of goods and services in an economy increases, the inflation rate
increases.
D) All of the above are true statements.
E) Only (a) and (b) of the above are true statements.
Answer: A
7) A stronger dollar benefits _____ and hurts _____.
A) American businesses; American consumers
B) American businesses; foreign businesses
C) American consumers; American businesses
D) foreign businesses; American consumers
Answer: C
8) Which of the following can be described as involving indirect finance?
A) You make a loan to your neighbor.
B) A corporation buys a share of common stock issued by another corporation.
C) You buy a U.S. Treasury bill from the U.S. Treasury.
D) You make a deposit at a bank.
Answer: D
9) Which of the following are long-term financial instruments?
A) A negotiable certificate of deposit
B) A banker's acceptance
C) A U.S. Treasury bond
D) A U.S. Treasury bill
Answer: C
10) Which of the following statements about the characteristics of debt and equity are true?
A) They can both be long-term financial instruments.
B) They can both be short-term financial instruments.
C) Debt is a claim on the issuer's assets, but equity is a claim on the issuer's income.
D) Both (a) and (b) of the above.
E) Both (a) and (c) of the above.
Answer: A
11) Which of the following instruments is not traded in a money market?
A) Banker's acceptances
B) U.S. Treasury Bills
C) Eurodollars
D) Commercial paper
E) Residential mortgages
Answer: E
12) Which of the following instruments are traded in a capital market?
A) U.S. Government agency securities
B) Negotiable bank CDs
C) Repurchase agreements
D) Banker's acceptances
E) None of the above
Answer: A
13) Which of the following is a depository institution?
A) A life insurance company
B) A credit union
C) A pension fund
D) A mutual fund
Answer: B
14) Bonds that are sold in a foreign country and are denominated in the country's currency in
which they are sold are known as
A) foreign bonds. B) Eurobonds. C) equity bonds. D) country bonds
Answer: A
15) A corporation acquires new funds only when its securities are sold
A) in the primary market by an investment bank.
B) in the primary market by a stock exchange broker.
C) in the secondary market by a securities dealer.
D) in the secondary market by a commercial bank.
Answer: A
16)
A potential borrower usually has better information about the potential returns and risk of
the investment projects he plans to undertake than does the lender. This inequality of
information is called
A) moral hazard.
B) asymmetric information.
C) reverse causation.
D) adverse selection.
Answer: B
17)
The problem created by asymmetric information before the transaction occurs is called
_____, while the problem created after the transaction occurs is called _____.
A) adverse selection; moral hazard
B) moral hazard; adverse selection
C) costly state verification; free-riding
D) free-riding; costly state verification
Answer: A
18) The difference between money and income is that
A) money is a flow and income is a stock.
B) money is a stock and income is a flow.
C) there is no difference--money and income are both stocks.
D) there is no difference--money and income are both flows.
Answer: B
19) Checkable deposits are money because
A) federal regulations mandate that they be so considered.
B) they serve the functions of money.
C) only banks, and not savings and loan associations, can issue checkable deposits.
D) of both (a) and (b) of the above.
E) of both (a) and (c) of the above.
Answer: B
20) If the price level doubles, the value of money
A) doubles.
B) more than doubles, due to scale economies.
C) rises but does not double, due to diminishing returns.
D) falls by 50 percent.
Answer: D
21) Recent financial innovation makes the Federal Reserve's job of conducting monetary policy
A) easier, since the Fed now knows what to consider money.
B) more difficult, since the Fed now knows what to consider money.
C) easier, since the Fed no longer knows what to consider money.
D) more difficult, since the Fed no longer knows what to consider money.
Answer: D
22) Which of the following is included in M2 but not in M1?
A) NOW accounts
B) Demand deposits
C) Currency
D) Money market mutual fund shares (noninstitutional)
E) gold coins issued by the U.S. Treasury
Answer: D
23) An examination of revised money supply statistics, when compared to the initial statistics,
suggests that
A) the initial statistics are pretty good.
B) the initial statistics do not provide a good guide to short-run movements in the money
supply.
C) the initial statistics provide a poor guide of monetary policy because they are usually
underestimates of the revised statistics.
D) the initial statistics provide a good guide of monetary policy, though they are usually
underestimates of the revised statistics.
Answer: B
24) If there are five goods in a barter economy, one needs to know ten prices in order to exchange
one good for another. If, however, there are ten goods in a barter economy, then one needs to
know _____ prices in order to exchange one good for another.
A) 20 B) 25 C) 30 D) 45
Answer: D
25) Which of the following statements accurately describes the three different measures of the
money supply--M1, M2, and M3?
A) The three measures do not move together, so they cannot be used interchangeably by
policymakers.
B) The three measures' movements closely parallel each other, even on a month-to-month
basis.
C) Short-run movements in the money supply are extremely reliable.
D) Both (a) and (c) of the above.
Answer: A
26) Which of the following $1,000 face-value securities has the highest yield to maturity?
A) A 5 percent coupon bond with a price of $600
B) A 5 percent coupon bond with a price of $800.
C) A 5 percent coupon bond with a price of $1,000.
D) A 5 percent coupon bond with a price of $1,200.
E) A 5 percent coupon bond with a price of $1,500.
Answer: A
27) The current yield, which equals the coupon payment divided by the price of a coupon bond, is
a less accurate measure of the yield to maturity the ______ the maturity of the bond and the
______ the price is from/to the par value.
A) shorter; closer B) shorter; farther C) longer; closer D) longer; farther
Answer: B
28) For simple loans, the simple interest rate is _____ the yield to maturity.
A) greater than
B) less than
C) equal to
D) not comparable to
Answer: C
29) A $4,000 coupon bond with a $480 coupon payment every year has a coupon rate of
A) 2 percent. B) 6 percent. C) 8 percent. D) 12 percent.
Answer: D
30) The _____ is a better approximation for the _____, the nearer the bond's price is to the bond's
par value and the longer the maturity of the bond.
A) current yield; yield to maturity
B) current yield; coupon rate
C) yield to maturity; current yield
D) yield to maturity; coupon rate
Answer: A
31) If you expect the inflation rate to be 5 percent next year and a one year bond has a yield to
maturity of 7 percent, then the real interest rate on this bond is
A) -12 percent. B) -2 percent. C) 2 percent. D) 12 percent.
Answer: C
32)
Which of the following are true concerning the distinction between interest rates and
return?
A) The rate of return on a bond will not necessarily equal the interest rate on that bond.
B) The return can be expressed as the difference between the current yield and the rate of
capital gains.
C) The rate of return will be greater than the interest rate when the price of the bond falls
between time t and time t+1.
D) All of the above are true.
E) Only (a) and (b) of the above are true.
Answer: A
33)
Which of the following are generally true of all bonds?
A) The longer a bond's maturity, the greater is the rate of return that occurs as a result of
the increase in the interest rate.
B) Even though a bond has a substantial initial interest rate, its return can turn out to be
negative if interest rates rise.
C) Prices and returns for short term bonds are more volatile than those for longer term
bonds.
D) All of the above are true.
E) Only (a) and (b) of the above are true.
Answer: B
34)
The _____ states that the nominal interest rate equals the real interest rate plus the expected
rate of inflation.
A) Fisher equation.
B) Keynesian equation.
C) Monetarist equation.
D) Marshall equation.
Answer: A
35)
If the expected return on CBS stock rises from 5 to 10 percent and the expected return on
NBC stock rises from 12 to 18 percent, then the expected return of holding CBS stock
_____ relative to NBC stock and the demand for CBS stock _____.
A) rises; rises B) rises; falls C) falls; rises D) falls; falls
Answer: D
36)
If fluctuations in interest rates become smaller, then, other things equal, the demand for
stocks _____ and the demand for long-term bonds _____.
A) increases; increases
B) increases; decreases
C) decreases; decreases
D) decreases; increases
Answer: D
37)
If housing prices are suddenly expected to shoot up, then, other things equal, the demand
for houses will _____ and that of Treasury bills will _____.
A) increase; increase
B) increase; decrease
C) decrease; decrease
D) decrease; increase
Answer: B
38)
When the interest rate on a bond is _____ the equilibrium interest rate, in the bond
market there is excess _____ and the interest rate will _____.
A) below; demand; rise
B) below; demand; fall
C) below; supply; fall
D) above; supply; rise
E) below; supply; rise
Answer: E
39)
When bonds become more widely traded, and as a consequence the market becomes
more liquid, the demand curve for bonds shifts to the _____ and the interest rate _____.
A) right; rises B) right; falls C) left; falls D) left; rises
Answer: B
40)
When prices in the art market become more uncertain,
A) the demand curve for bonds shifts to the left and the interest rate rises.
B) the demand curve for bonds shifts to the left and the interest rate falls.
C) the demand curve for bonds shifts to the right and the interest rate falls.
D) the supply curve for bonds shifts to the right and the interest rate falls.
Answer: C
PART TWO: Problems (Total 60 points)
Question 1: (Total 10 points)
BRIEFLY define/explain the following:
a) Money: anything generally accepted as a means of payment for goods and services or
in the repayment of debts. (2 points)
b) Unit of account: agreed measure for stating prices of goods and services (OR measure
of value) in the economy. (2 points)
c) Discounting: converting a future amount of money to a present value OR calculating
what dollars received in the future are worth today. (2 points)
d) Why is it true that in a world with easy accessibility to information and without
transactions costs, financial intermediaries would not exist?
If there is easy accessibility to information and no transactions costs, people could make
loans to each other at no costs, and would thus have no need for financial intermediaries.
(2 points)
e) State two advantages of money market securities (compared to capital market securities)?
Money market securities have smaller price fluctuations (less volatile) than capital
market securities and are considered to be less risky investments (1 point: if you say less
volatile or less risky). They are also more widely traded and so tend to be more liquid.
(2 points)
Question 2: (Total 25 points)
Suppose you are thinking of buying a $1000 face-value coupon bond with a coupon rate of 10%,
a maturity of 3 years, and a price of $1079. (Please show your equations and work when
answering the questions below.)
a. Is the yield to maturity going to be above or below 10%? Why? (3.5 points)
Below (2 points), because the price of the bond ($1079) is above the par or face value of
the bond ($1000) (1.5 points).
b. Write down the equation that can be solved for the yield to maturity of this bond. (3.5
points)
P
C
C
C
F



2
3
(1  i ) (1  i )
(1  i )
(1  i ) 3
where P is the price of the coupon bond, C is the yearly coupon payment, F is the face
value
of the bond. i is the yield to maturity and the years to maturity date = 3 years. So the
equation
to be solved for the yield to maturity of this bond is:
$1079 
$100
$100
$100
$1000



2
3
(1  i ) (1  i )
(1  i )
(1  i ) 3
c. Calculate the present value of the bond when the interest rate is 8%. (3 points)
PV 
$100
$100
$100
$1000



 $1052
2
3
(1  0.08) (1  0.08)
(1  0.08)
(1  0.08) 3
d. Must the yield to maturity be above or below 8%? (Hint: Is the yield to maturity for a
present value of $1079 higher or lower than the yield to maturity of the present value
calculated in part 3?) (3 points)
The yield to maturity will be below 8% since $1079 is a higher price than $1052 and
therefore will have a lower interest rate (negative relationship between the interest rate
and the price of the bond).
e. Calculate the present value of the bond when the interest rate is 5%. (3 points)
PV 
f.
$100
$100
$100
$1000



 $1136
2
3
(1  0.05) (1  0.05)
(1  0.05)
(1  0.05) 3
Must the yield to maturity be above or below 5%? (Hint: Is the yield to maturity for a
present value of $1079 higher or lower than the yield to maturity of the present value
calculated in part 5?) (3 points)
The yield to maturity will be above 5% since $1079 is a lower price than $1136 and
therefore will have a higher interest rate (negative relationship between the interest rate
and the price of the bond).
g. What do your answers in parts 4 and 6 tell you about the relationship between interest
rates and the prices of bonds? (2 points)
The answers show the negative relationship between interest rates and prices of bonds.
h. Calculate the rate of return on the coupon bond if the bond was bought for $1000, held
for one year and then sold for $1079. Would you purchase this bond and why? (4 points)
RET 
C ( Pt 1  Pt )

Pt
Pt
where RET is the rate of return, Pt is the price of the bond at
period t, and Pt+1 is the price of the bond at time t+1.
RET 
$100 ($1079  $1000)

 17.9%
$1000
$1000
(2 points)
Yes, I would purchase this bond because it has a positive return. (2 points)
Question 3: (Total 25 points)
Using the Loanable Funds framework, explain and graphically show what happens to interest
rates in the situations listed below. Show how the supply and/or demand curves would shift and
why. Please mark your graph(s) clearly.
Your graph in each case should show both the supply and demand curves with the initial
equilibrium point and then the new equilibrium point resulting from a shift in the demand or
supply curve (see Figure 9 on page 113 for an example). All graphs should be clearly marked
(1 point)
a)
A recession (8 points)
Demand for bonds:
Recession  a reduction in wealth  less income and resources to purchase assets   Bd and
the Bd curve shifts to the left and there is an increase in the interest rate. (4 points)
Supply of bonds:
Recession  lack of investment opportunities  less borrowing   Bs and the Bs curve shifts
to the left and there is a decrease in the interest rate. (4 points)
Note that if you used one graph to show both shifts in the demand and the supply curves then the
resulting interest rate (at the new equilibrium point) may be higher or lower depending on the
magnitude of the shift. For example, if the leftward shift in the supply curve is greater than the
leftward shift in the demand curve, the interest rate would decrease. If the leftward shift in the
demand curve is greater than that of the supply curve then the interest rate would increase. If the
magnitude of the shift is the same for both supply and demand, then the interest rate will remain
unchanged. (Any of these three scenarios is acceptable as long as you explain your work.)
b)
Expected deflation (8 points)
Demand for bonds:
Deflation  a decrease in the price of real assets   Bd (demand for bonds) as the expected
rate of return (RETe) on real assets decreases   RETe on bonds relative to the RETe on real
assets  Bd curve shifts to the right and there is a decrease in the interest rate. (4 points)
Supply of bonds:
Deflation  an increase in real interest rates   cost of borrowing   Bs (supply of bonds)
and the Bs curve shifts to the left and there is a decrease in the interest rate. (4 points)
If you show the shifts in supply and demand curves on one graph, then the rightward shift in the
demand curve and the leftward shift in the supply curve would result in a decrease in the interest
rate.
c)
Increase in expected interest rate
Higher expected interest rate  expected return today on long-term bonds (due to the negative
relationship between the price of the bond and the interest rate)   Bd (demand for bonds) and
the Bd curve shifts to the left and there is an increase in the interest rate. (4 points)
d)
Decrease in government deficit
Lower government deficits  borrowing by the government  less bonds sold by US
Treasury  Bs (supply of bonds) and Bs curve shifts to the left and there is a decrease in the
interest rate. (4 points)
Hint: There are two cases where only the supply OR demand curve shifts and two cases where
both the supply AND demand curves shift.
Extra Credit Question: Please attempt the extra credit question only after you have completed
and preferably reviewed the entire exam. (Total 10 points)
What does the theory of asset demand state i.e., what are the determinants of asset demand and
how are they related to the quantity demanded of an asset?
According to the Theory of Asset Demand:
The quantity demanded of an asset is positively related to:
1) Wealth (2.5 points)
2) expected return of the asset relative to alternative assets (2.5 points)
3) liquidity of the asset relative to alternative assets (2.5 points)
and the quantity demanded of an asset is negatively related to
4) risk of the returns of that asset relative to alternative assets. (2.5 points)