978-0134733821 Chapter 5 Solution Manual

Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 80

Chapter 5

ANSWERS TO QUESTIONS

1. Explain why you would be more or less willing to buy a share of Microsoft stock in the

following situations:

a. Your wealth falls.

b. You expect the stock to appreciate in value.

c. The bond market becomes more liquid.

d. You expect gold to appreciate in value.

e. Prices in the bond market become more volatile.

2. Explain why you would be more or less willing to buy a house under the following

circumstances:

a. You just inherited $100,000.

b. Real estate commissions fall from 6% of the sales price to 5% of the sales price.

c. You expect Microsoft stock to double in value next year

d. Prices in the stock market become more volatile.

e. You expect housing prices to fall.

3. Explain why you would be more or less willing to buy gold under the following

circumstances:

a. Gold again becomes acceptable as a medium of exchange.

Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 81

b. Prices in the gold market become more volatile.

c. You expect inflation to rise, and gold prices tend to move with the aggregate price level.

d. You expect interest rates to rise.

4. Explain why you would be more or less willing to buy long-term AT&T bonds under the

following circumstances:

a. Trading in these bonds increases, making them easier to sell.

b. You expect a bear market in stocks (stock prices are expected to decline).

c. Brokerage commissions on stocks fall.

d. You expect interest rates to rise.

e. Brokerage commissions on bonds fall.

5. What will happen to the demand for Rembrandt paintings if the stock market undergoes a

boom? Why?

6. Raphael observes that at the current level of interest rates there is an excess supply of bonds

and therefore he anticipates an increase in the price of bonds. Is Raphael correct?

Raphael is incorrect. If at the current level of interest rates there is an excess supply of bonds,

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supply curve than the rightward shift in the bond demand curve would then result in a rise in

bond prices and a fall in interest rates. In addition, due to the severity of the global crisis, U.S.

treasury debt became a safe haven investment, reducing relative risk and increasing liquidity

for U.S. treasury debt. This significantly raised U.S. treasury bond demand, leading to higher

bond prices and significantly lower yields. In other words, the decrease in investment

opportunities and risk factors significantly offset the wealth effect on demand and the deficit

effect on supply.

12. Will there be an effect on interest rates if brokerage commissions on stocks fall? Explain

your answer.

13. The president of the United States announces in a press conference that he will fight the higher

inflation rate with a new anti-inflation program. Predict what will happen to interest rates if

the public believes him.

If the public believes the president’s program will be successful, interest rates will fall. The

14. 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?

15. Suppose you are in charge of the financial department of your company and you have to

decide whether to borrow short or long term. Checking the news, you realize that the

government is about to engage in a major infrastructure plan in the near future. Predict what

will happen to interest rates. Will you advise borrowing short or long term?

If the government is planning to fund a major infrastructure plan, it will need to get funds,

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ANSWERS TO APPLIED PROBLEMS

20. Suppose you visit with a financial adviser, and you are considering investing some of your

wealth in one of three investment portfolios: stocks, bonds, or commodities. Your financial

adviser provides you with the following table, which gives the probabilities of possible

returns from each investment:

Stocks

Bonds

Commodities

Probability

Return

Probability

Return

Probability

Return

0.25

12%

0.6

10%

0.2

20%

0.25

10%

0.4

7.50%

0.25

12%

0.25

8%

0.25

6%

0.25

6%

0.25

4%

0.05

0%

a. Which investment should you choose to maximize your expected return: stocks, bonds, or

commodities?

b. If you are risk-averse and have to choose between the stock and the bond investments,

which should you choose? Why?

21. An important way in which the Federal Reserve decreases the money supply is by selling

bonds to the public. Using a supply and demand analysis for bonds, show what effect this

action has on interest rates. Is your answer consistent with what you would expect to find

with the liquidity preference framework?

When the Fed sells bonds to the public, it increases the supply of bonds, thus shifting the

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Suppose that, as a result of monetary policy actions, the Federal Reserve sells 80 bonds that

it holds. Assume that bond demand and money demand are held constant.

a. How does the Federal Reserve policy affect the bond supply equation?

b. Calculate the effect of the Federal Reserve’s action on the equilibrium interest rate in

this market.

As a result of the Federal Reserve action, the new equilibrium is given as:

–0.6 Quantity + 1140 = Quantity + 620;

ANSWERS TO DATA ANALYSIS PROBLEMS

1. 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.

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2. Go to the St. Louis Federal Reserve FRED database, and find data on the M1 money supply

(M1SL) and the 10-year U.S. treasury bond rate. For the M1 money supply indicator, adjust

the units setting to “Percent Change from Year Ago,” and for the 10-year treasury bond,

adjust the frequency setting to “Quarterly.” Download the data into a spreadsheet.

a. Create a scatter plot, with money growth on the horizontal axis and the 10-year treasury

rate on the vertical axis, from 2000:Q1 to the most recent quarter of data available. On

the scatter plot, graph a fitted (regression) line of the data (there are several ways to do

this; however, one particular chart layout has this option built in). Based on the fitted

line, are the data consistent with the liquidity effect? Briefly explain.

b. Repeat part (a), but this time compare the contemporaneous money growth rate with the

interest rate four quarters later. For example, create a scatter plot comparing money

growth from 2000:Q1 with the interest rate from 2001:Q1, and so on, up to the most

recent pairwise data available. Compare your results to those obtained in part (a), and

interpret the liquidity effect as it relates to the income, price-level, and expected-inflation

effects.

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quarter as in (a) above, but it was lowered by only 14 basis points one year later, then the

feedback effects from the income, price-level, and expected inflation effect must be

helping to offset some of the liquidity effect (on the order of around 2.6 basis points)

after one year, on average.

c. Repeat part (a) again, except this time compare the contemporaneous money growth rate

with the interest rate eight quarters later. For example, create a scatter plot comparing

money growth from 2000:Q1 with the interest rate from 2002:Q1, and so on, up to the

most recent pairwise data available. Assuming the liquidity and other effects are fully

incorporated into the bond market after two years, what do your results imply about the

overall effect of money growth on interest rates?

See scatterplot below. Assuming all the effects run its course after two years, the data

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d. Based on your answers to parts (a) through (c), how do the actual data on money growth

and interest rates compare to the three scenarios presented in Figure 11 of this chapter?