Chapter 4
Why Do Interest Rates Change?
◼ Multiple Choice Questions
1. As the price of a bond _________ and the expected return _________, bonds become more
attractive to investors and the quantity demanded rises.
(a) falls; rises
(b) falls; falls
(c) rises; rises
(d) rises; falls
2. The supply curve for bonds has the usual upward slope, indicating that as the price _________,
ceteris paribus, the _________ increases.
(a) falls; supply
(b) falls; quantity supplied
(c) rises; supply
(d) rises; quantity supplied
3. When the price of a bond is above the equilibrium price, there is excess _________ in the bond
market and the price will _________.
(a) demand; rise
(b) demand; fall
(c) supply; fall
(d) supply; rise
4. When the price of a bond is below the equilibrium price, there is excess _________ in the bond
market and the price will _________.
(a) demand; rise
(b) demand; fall
(c) supply; fall
(d) supply; rise
Chapter 4 Why Do Interest Rates Change? 35
5. When the price of a bond is _________ the equilibrium price, there is an excess supply of bonds and
the price will _________.
(a) above; rise
(b) above; fall
(c) below; fall
(d) below; rise
6. When the price of a bond is _________ the equilibrium price, there is an excess demand for bonds
and the price will _________.
(a) above; rise
(b) above; fall
(c) below; fall
(d) below; rise
7. When the interest rate on a bond is above the equilibrium interest rate, there is excess _________ in
the bond market and the interest rate will _________.
(a) demand; rise
(b) demand; fall
(c) supply; fall
(d) supply; rise
8. When the interest rate on a bond is below the equilibrium interest rate, there is excess _________ in
the bond market and the interest rate will _________.
(a) demand; rise
(b) demand; fall
(c) supply; fall
(d) supply; rise
9. When the interest rate on a bond is _________ the equilibrium interest rate, there is excess
_________ in the bond market and the interest rate will _________.
(a) above; demand; fall
(b) above; demand; rise
(c) below; supply; fall
(d) above; supply; rise
10. When the interest rate on a bond is _________ the equilibrium interest rate, there is excess
_________ in the bond market and the interest rate will _________.
(a) below; demand; rise
(b) below; demand; fall
(c) below; supply; rise
(d) above; supply; fall
36 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
11. When the demand for bonds _________ or the supply of bonds _________, interest rate rise.
(a) increases; increases
(b) increases; decreases
(c) decreases; decreases
(d) decreases; increases
12. When the demand for bonds _________ or the supply of bonds _________, interest rates fall.
(a) increases; increases
(b) increases; decreases
(c) decreases; decreases
(d) decreases; increases
13. When the demand for bonds _________ or the supply of bonds _________, bond prices rise.
(a) increases; decreases
(b) decreases; increases
(c) decreases; decreases
(d) increases; increases
14. When the demand for bonds _________ or the supply of bonds _________, bond prices fall.
(a) increases; increases
(b) increases; decreases
(c) decreases; decreases
(d) decreases; increases
15. Factors that determine the demand for an asset include changes in the
(a) wealth of investors.
(b) liquidity of bonds relative to alternative assets.
(c) expected returns on bonds relative to alternative assets.
(d) risk of bonds relative to alternative assets.
(e) all of the above.
16. The demand for an asset rises if _________ falls.
(a) risk relative to other assets
(b) expected return relative to other assets
(c) liquidity relative to other assets
(d) wealth
Chapter 4 Why Do Interest Rates Change? 37
17. The higher the standard deviation of returns on an asset, the _________ is the asset’s _________.
(a) greater; risk
(b) smaller; risk
(c) greater; expected return
(d) smaller; expected return
18. Diversification benefits an investor by
(a) increasing wealth.
(b) increasing expected return.
(c) reducing risk.
(d) increasing liquidity.
19. In a recession when income and wealth are falling, the demand for bonds _________ and the
demand curve shifts to the _________.
(a) falls; right
(b) falls; left
(c) rises; right
(d) rises; left
20. During business cycle expansions when income and wealth are rising, the demand for bonds
_________ and the demand curve shifts to the _________.
(a) falls; right
(b) falls; left
(c) rises; right
(d) rises; left
21. For a holding period of one year, the expected return on a consol is _________ the higher is the
price of the consol today, and _________ the higher is the price of the consol next year.
(a) higher; higher
(b) higher; lower
(c) lower; higher
(d) lower; lower
22. Higher expected interest rates in the future _________ the demand for long-term bonds and shift the
demand curve to the _________.
(a) increase; left
(b) increase; right
(c) decrease; left
(d) decrease; right
38 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
23. Lower expected interest rates in the future _________ the demand for long-term bonds and shift the
demand curve to the _________
(a) increase; left.
(b) increase; right.
(c) decrease; left.
(d) decrease; right.
24. When people begin to expect a large stock market decline, the demand curve for bonds shifts to the
_________ and the interest rate _________.
(a) right; falls
(b) right; rises
(c) left; falls
(d) left; rises
25. When people begin to expect a large run up in stock prices, the demand curve for bonds shifts to the
_________ and the interest rate _________.
(a) right; rises
(b) right; falls
(c) left; falls
(d) left; rises
26. An increase in the expected rate of inflation will _________ the expected return on bonds relative to
that on _________ assets, and shift the _________ curve to the left.
(a) reduce; financial; demand
(b) reduce; real; demand
(c) raise; financial; supply
(d) raise; real; supply
27. A decrease in the expected rate of inflation will _________ the expected return on bonds relative to
that on _________ assets.
(a) reduce; financial
(b) reduce; real
(c) raise; financial
(d) raise; real
28. When the expected inflation rate increases, the demand for bonds _________, the supply of bonds
_________, and the interest rate _________.
(a) increases; increases; rises
(b) decreases; decreases; falls
(c) increases; decreases; falls
(d) decreases; increases; rises
Chapter 4 Why Do Interest Rates Change? 39
29. When the expected inflation rate decreases, the demand for bonds _________, the supply of bonds
_________, and the interest rate __________.
(a) increases; increases; rises
(b) decreases; decreases; falls
(c) increases; decreases; falls
(d) decreases; increases; rises
30. When bond interest rates become more volatile, the demand for bonds _________ and the interest
rate _________.
(a) increases; rises
(b) increases; falls
(c) decreases; falls
(d) decreases; rises
31. When bond interest rates become less volatile, the demand for bonds _________ and the interest rate
_________.
(a) increases; rises
(b) increases; falls
(c) decreases; falls
(d) decreases; rises
32. When prices in the stock market become more uncertain, the demand curve for bonds shifts to the
_________ and the interest rate _________.
(a) right; rises
(b) right; falls
(c) left; falls
(d) left; rises
33. When stock prices become less volatile, the demand curve for bonds shifts to the _________ and the
interest rate _________.
(a) right; rises
(b) right; falls
(c) left; falls
(d) left; rises
34. 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
40 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
35. When bonds become less widely traded, and as a consequence the market becomes less 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
36. Factors that cause the demand curve for bonds to shift to the left include
(a) an increase in the inflation rate.
(b) an increase in the liquidity of stocks.
(c) a decrease in the volatility of stock prices.
(d) all of the above.
(e) none of the above.
37. Factors that cause the demand curve for bonds to shift to the left include
(a) a decrease in the inflation rate.
(b) an increase in the volatility of stock prices.
(c) an increase in the liquidity of stocks.
(d) all of the above.
(e) only (a) and (b) of the above.
38. During an economic expansion, the supply of bonds _________ and the supply curve shifts to the
_________.
(a) increases, left
(b) increases, right
(c) decreases, left
(d) decreases, right
39. During a recession, the supply of bonds _________ and the supply curve shifts to the _________.
(a) increases, left
(b) increases, right
(c) decreases, left
(d) decreases, right
Chapter 4 Why Do Interest Rates Change? 41
40. An increase in expected inflation causes the supply of bonds to _________ and the supply curve to
shift to the _________.
(a) increase, left
(b) increase, right
(c) decrease, left
(d) decrease, right
41. When the federal government’s budget deficit increases, the _________ curve for bonds shifts to the
_________.
(a) demand; right
(b) demand; left
(c) supply; left
(d) supply; right
42. When the federal government’s budget deficit decreases, the _________ curve for bonds shifts to
the _________.
(a) demand; right
(b) demand; left
(c) supply; left
(d) supply; right
43. When the inflation rate is expected to increase, the expected return on bonds relative to real assets
falls for any given interest rate; as a result, the _________ bonds falls and the _________ curve
shifts to the left.
(a) demand for; demand
(b) demand for; supply
(c) supply of; demand
(d) supply of; supply
44. When the inflation rate is expected to increase, the real cost of borrowing declines at any given
interest rate; as a result, the _________ bonds increases and the _________ curve shifts to the right.
(a) demand for; demand
(b) demand for; supply
(c) supply of; demand
(d) supply of; supply
42 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
Figure 4.1
45. In Figure 4.1, the most likely cause of the increase in the equilibrium interest rate from i1 to i2 is
(a) an increase in the price of bonds.
(b) a business cycle boom.
(c) an increase in the expected inflation rate.
(d) a decrease in the expected inflation rate.
46. In Figure 4.1, the most likely cause of the increase in the equilibrium interest rate from i1 to i2 is a(n)
_________ in the _________.
(a) increase; expected inflation rate
(b) decrease; expected inflation rate.
(c) increase; government budget deficit
(d) decrease; government budget deficit
47. In Figure 4.1, the most likely cause of a decrease in the equilibrium interest rate from i2 to i1 is
(a) an increase in the expected inflation rate.
(b) a decrease in the expected inflation rate.
(c) a business cycle expansion.
(d) a combination of both (a) and (c) of the above.
48. Factors that can cause the supply curve for bonds to shift to the right include
(a) an expansion in overall economic activity.
(b) a decrease in expected inflation.
(c) a decrease in government deficits.
(d) all of the above.
(e) only (a) and (b) of the above.
Chapter 4 Why Do Interest Rates Change? 43
49. Factors that can cause the supply curve for bonds to shift to the left include
(a) an expansion in overall economic activity.
(b) a decrease in expected inflation.
(c) an increase in government deficits.
(d) only (a) and (c) of the above.
50. The economist Irving Fisher, after whom the Fisher effect is named, explained why interest rates
_________ as the expected rate of inflation _________.
(a) rise; increases
(b) rise; stabilizes
(c) rise; decreases
(d) fall; increases
(e) fall; stabilizes
51. An increase in the expected rate of inflation causes the demand for bonds to _________ and the
supply for bonds to _________.
(a) fall; fall
(b) fall; rise
(c) rise; fall
(d) rise; rise
52. A decrease in the expected rate of inflation causes the demand for bonds to _________ and the
supply of bonds to _________.
(a) fall; fall
(b) fall; rise
(c) rise; fall
(d) rise; rise
53. When the economy slips into a recession, normally the demand for bonds _________, the supply of
bonds _________, and the interest rate _________.
(a) increases; increases; rises
(b) decreases; decreases; falls
(c) increases; decreases; falls
(d) decreases; increases; rises
54. When the economy enters into a boom, normally the demand for bonds _________,
the supply of bonds _________, and the interest rate _________.
(a) increases; increases; rises
(b) decreases; decreases; falls
(c) increases; decreases; rises
(d) decreases; increases; rises
44 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
Answer: A
Figure 4.2
55. In Figure 4.2, one possible explanation for the increase in the interest rate from i1 to i2 is a(n)
_________ in _________.
(a) increase; the expected inflation rate
(b) decrease; the expected inflation rate
(c) increase; economic growth
(d) decrease; economic growth
56. In Figure 4.2, one possible explanation for the increase in the interest rate from i1 to i2 is
(a) an increase in economic growth.
(b) an increase in government budget deficits.
(c) a decrease in government budget deficits.
(d) a decrease in economic growth.
(e) a decrease in the riskiness of bonds relative to other investments.
57. In Figure 4.2, one possible explanation for a decrease in the interest rate from i2 to i1 is
(a) an increase in government budget deficits.
(b) an increase in expected inflation.
(c) a decrease in economic growth.
(d) a decrease in the riskiness of bonds relative to other investments.
Questions for Chapter 4, Web Appendix 2: Supply and Demand in the Market for Money: The Liquidity
Preference Framework
58. In Keynes’s liquidity preference framework, individuals are assumed to hold their wealth in two
forms:
(a) real assets and financial assets.
(b) stocks and bonds.
(c) money and bonds.
(d) money and gold.
Chapter 4 Why Do Interest Rates Change? 45
59. In his liquidity preference framework, Keynes assumed that money has a zero rate of return; thus,
when interest rates _________ the expected return on money falls relative to the expected return on
bonds, causing the demand for money to _________.
(a) rise; fall
(b) rise; rise
(c) fall; fall
(d) fall; rise
60. The loanable funds framework is easier to use when analyzing the effects of changes in _________,
while the liquidity preference framework provides a simpler analysis of the effects from changes in
income, the price level, and the supply of _________
(a) expected inflation; bonds.
(b) expected inflation; money.
(c) government budget deficits; bonds.
(d) the supply of money; bonds.
61. When comparing the loanable funds and liquidity preference frameworks of interest rate
determination, which of the following is true?
(a) The liquidity preference framework is easier to use when analyzing the effects of changes in
expected inflation.
(b) The loanable funds framework provides a simpler analysis of the effects of changes in income,
the price level, and the supply of money.
(c) In most instances, the two approaches to interest rate determination yield the same predictions.
(d) All of the above are true.
(e) Only (a) and (b) of the above are true.
62. A higher level of income causes the demand for money to _________ and the interest rate to
_________
(a) decrease; decrease.
(b) decrease; increase.
(c) increase; decrease.
(d) increase; increase.
63. A lower level of income causes the demand for money to _________ and the interest rate to
_________
(a) decrease; decrease.
(b) decrease; increase.
(c) increase; decrease.
(d) increase; increase.
46 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
64. A rise in the price level causes the demand for money to _________ and the demand curve to shift
to the _________
(a) decrease; right.
(b) decrease; left.
(c) increase; right.
(d) increase; left.
65. A decline in the price level causes the demand for money to _________ and the demand curve to
shift to the _________
(a) decrease; right.
(b) decrease; left.
(c) increase; right.
(d) increase; left.
66. A decline in the expected inflation rate causes the demand for money to _________ and the demand
curve to shift to the _________
(a) decrease; right.
(b) decrease; left.
(c) increase; right.
(d) increase; left.
67. Holding everything else constant, an increase in the money supply causes
(a) interest rates to decline initially.
(b) interest rates to increase initially.
(c) bond prices to decline initially.
(d) both (a) and (c) of the above.
(e) both (b) and (c) of the above.
68. Holding everything else constant, a decrease in the money supply causes
(a) interest rates to decline initially.
(b) interest rates to increase initially.
(c) bond prices to increase initially.
(d) both (a) and (c) of the above.
(e) both (b) and (c) of the above.
Chapter 4 Why Do Interest Rates Change? 47
Figure 4.3
69. In Figure 4.3, the factor responsible for the decline in the interest rate is
(a) a decline in the price level.
(b) a decline in income.
(c) an increase in the money supply.
(d) a decline in the expected inflation rate.
70. In Figure 4.3, the decrease in the interest rate from i1 to i2 can be explained by
(a) a decrease in money growth.
(b) an increase in money growth.
(c) a decline in the expected price level.
(d) only (a) and (b) of the above.
71. In Figure 4.3, an increase in the interest rate from i2 to i1 can be explained by
(a) a decrease in money growth.
(b) an increase in money growth.
(c) a decline in the price level.
(d) an increase in the expected price level.
72. Of the four effects on interest rates from an increase in the money supply, the one that works in the
opposite direction of the other three is the
(a) liquidity effect.
(b) income effect.
(c) price level effect.
(d) expected inflation effect.
73. Of the four effects on interest rates from an increase in the money supply, the initial effect is,
generally, the
(a) income effect.
(b) liquidity effect.
(c) price level effect.
(d) expected inflation effect.
48 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
74. If the liquidity effect is smaller than the other effects, and the adjustment of expected inflation is
slow, then the
(a) interest rate will fall.
(b) interest rate will rise.
(c) interest rate will initially fall but eventually climb above the initial level in response to an
increase in money growth.
(d) interest rate will initially rise but eventually fall below the initial level in response to an increase
in money growth.
75. When the growth rate of the money supply increases, interest rates end up being permanently lower if
(a) the liquidity effect is larger than the other effects.
(b) there is fast adjustment of expected inflation.
(c) there is slow adjustment of expected inflation.
(d) the expected inflation effect is larger than the liquidity effect.
76. When the growth rate of the money supply decreases, interest rates end up being permanently
lower if
(a) the liquidity effect is larger than the other effects.
(b) there is fast adjustment of expected inflation.
(c) there is slow adjustment of expected inflation.
(d) the expected inflation effect is larger than the liquidity effect.
77. When the growth rate of the money supply is decreased, interest rates will rise immediately if the
liquidity effect is _________ than the other effects and if there is _________ adjustment of expected
inflation.
(a) larger; rapid
(b) larger; slow
(c) smaller; slow
(d) smaller; rapid
78. When the growth rate of the money supply is increased, interest rates will rise immediately if the
liquidity effect is _________ than the other effects and if there is _________ adjustment of expected
inflation.
(a) larger; rapid
(b) larger; slow
(c) smaller; slow
(d) smaller; rapid
Chapter 4 Why Do Interest Rates Change? 49
79. If the Fed wants to permanently lower interest rates, then it should lower the rate of money growth if
(a) there is fast adjustment of expected inflation.
(b) there is slow adjustment of expected inflation.
(c) the liquidity effect is smaller than the expected inflation effect.
(d) the liquidity effect is larger than the other effects.
80. If the Fed wants to permanently lower interest rates, then it should raise the rate of money growth if
(a) there is fast adjustment of expected inflation.
(b) there is slow adjustment of expected inflation.
(c) the liquidity effect is smaller than the expected inflation effect.
(d) the liquidity effect is larger than the other effects.
81. Milton Friedman contends that it is entirely possible that when the money supply rises, interest rates
may _________ if the _________ effect is more than offset by changes in income, the price level,
and expected inflation.
(a) fall; liquidity
(b) fall; risk
(c) rise; liquidity
(d) rise; risk
Answer: C
Figure 4.4
82. Figure 4.4 illustrates the effect of an increased rate of money supply growth. From the figure, one
can conclude that the liquidity effect is _________ than the expected inflation effect and interest
rates adjust _________ to changes in expected inflation.
(a) smaller; quickly
(b) larger; quickly
(c) larger; slowly
(d) smaller; slowly
50 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
83. Figure 4.4 illustrates the effect of an increased rate of money supply growth. From the figure, one
can conclude that the
(a) Fisher effect is dominated by the liquidity effect and interest rates adjust slowly to changes in
expected inflation.
(b) liquidity effect is dominated by the Fisher effect and interest rates adjust slowly to changes in
expected inflation.
(c) liquidity effect is dominated by the Fisher effect and interest rates adjust quickly to changes in
expected inflation.
(d) Fisher effect is smaller than the expected inflation effect and interest rates adjust quickly to
changes in expected inflation.
84. Figure 4.5 illustrates the effect of an increased rate of money supply growth. From the figure, one
can conclude that the liquidity effect is _________ than the expected inflation effect and interest
rates adjust _________ to changes in expected inflation.
(a) smaller; quickly
(b) larger; quickly
(c) larger; slowly
(d) smaller; slowly
85. Figure 4.5 illustrates the effect of an increased rate of money supply growth. From the figure, one
can conclude that the
(a) Fisher effect is dominated by the liquidity effect and interest rates adjust slowly to changes in
expected inflation.
(b) liquidity effect is dominated by the Fisher effect and interest rates adjust slowly to changes in
expected inflation.
(c) liquidity effect is dominated by the Fisher effect and interest rates adjust quickly to changes in
expected inflation.
(d) Fisher effect is smaller than the expected inflation effect and interest rates adjust quickly to
changes in expected inflation.
Chapter 4 Why Do Interest Rates Change? 51
◼ True/False
1. When interest rates decrease, the demand curve for bonds shifts to the left.
2. When an economy grows out of a recession, normally the demand for bonds increases and the
supply of bonds increases.
3. When the federal government’s budget deficit decreases, the demand curve for bonds shifts to the
right.
4. Investors make their choices of which assets to hold by comparing the expected return, liquidity, and
risk of alternative assets.
5. A person who is risk averse prefers to hold assets that are more, not less, risky.
6. Interest rates are procyclical in that they tend to rise during business cycle expansions and fall
during recessions.
7. When income and wealth are rising, the demand for bonds rises and the demand curve shifts to the
right.
8. An increase in the inflation rate will cause the demand curve for bonds to shift to the right.
9. The Fisher Effect predicts that an incease in expected inflation will lower the interest rate on bonds.
10. An increase in the federal government budget deficit will raise the interest rate on bonds.
52 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
◼ Essay
1. Identify and explain the four factors that influence asset demand. Which of these factors affect total
asset demand and which influence investors to demand one asset over another?
2. How is the equilibrium interest rate determined in the bond market? Explain why the interest rate
will move toward equilibrium if it is temporarily above or below the equilibrium rate.
3. Use the bond demand and supply framework to explain the Fisher effect and why it occurs.
4. If investors perceive greater interest rate risk, what will happen to the equilibrium interest rate in the
bond market? Explain using the bond demand and supply framework.
5. How will a decrease in the federal government’s budget deficit affect the equilibrium interest rate in
the bond maket? Explain using the bond demand and supply framework.
6. What is the expected return on a bond if the return is 9% two-thirds of the time and 3% one-third of
the time? What is the standard deviation of the returns on this bond? Would you prefer this bond or
one with an identical expected return and a standard deviation of 4.5? Why?