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.
Less, because it has become less liquid relative to bonds
d. You expect gold to appreciate in value.
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.
More, because the house has become more liquid
c. You expect Microsoft stock to double in value next year
d. Prices in the stock market become more volatile.
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.
More, because its expected return has risen
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.
More, because the bonds have become more liquid
b. You expect a bear market in stocks (stock prices are expected to decline).
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?
7. Suppose Maria prefers to buy a bond with a 7% expected return and 2% standard deviation
of its expected return, while Jennifer prefers to buy a bond with a 4% expected return and
1% standard deviation of its expected return. Can you tell if Maria is more or less risk-
averse than Jennifer?
Maria is choosing a bond with higher standard deviation, but also with higher expected return
than Jennifer. In order to decide whether Maria or Jennifer is more risk averse, one will need
8. What will happen in the bond market if the government imposes a limit on the amount of
daily transactions? Which characteristic of an asset would be affected?
If the government imposes a limit on the amount of daily transactions in the bond market,
9. How might a sudden increase in people’s expectations of future real estate prices affect
interest rates?
10. Suppose that many big corporations decide not to issue bonds, since it is now too costly to
comply with new financial market regulations. Can you describe the expected effect on
interest rates?
If many big corporations decide not to issue bonds because of new financial markets
11. In the aftermath of the global economic crisis that started to take hold in 2008, U.S.
government budget deficits increased dramatically, yet interest rates on U.S. Treasury debt fell
sharply and stayed low for quite some time. Does this make sense? Why or why not?
Given the answer to question 10 above, the supply effect of large deficits should lead to higher
12. Will there be an effect on interest rates if brokerage commissions on stocks fall? Explain
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
president’s announcement will lower expected inflation so that the expected return on goods
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?
If people in France decide to permanently increase their savings rate, then more wealth will
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,
16. Would fiscal policymakers ever have reason to worry about potentially inflationary
conditions? Why or why not?
Yes, fiscal policymakers should worry about potentially inflationary conditions. If people
17. Why should a rise in the price level (but not in expected inflation) cause interest rates to rise
when the nominal money supply is fixed?
When the price level rises, the quantity of money in real terms falls (holding the nominal
18. If the next chair of the Federal Reserve Board has a reputation for advocating an even
slower rate of money growth than the current chair, what will happen to interest rates?
Discuss the possible resulting situations.
Slower rate of money growth will lead to a liquidity effect, which raises interest rates, while
the lower price level, income, and inflation rates in the future will tend to lower interest rates.
19. M1 money growth in the U.S. was about 15% in 2011 and 2012, and 10% in 2013. Over the
same time period, the yield on 3-month Treasury bills was close to 0%. Given these high
rates of money growth, why did interest rates stay so low, rather than increase? What does
this say about the income, price-level, and expected-inflation effects?
With unusually high rates of money growth, this should lead to higher expected inflation, a
jump in the overall price level, and stronger economic growth. These factors should all result
Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 85
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%
a. Which investment should you choose to maximize your expected return: stocks, bonds, or
commodities?
The expected return on the stock portfolio is 0.25(12%) + 0.25(10%) + 0.25(8%) +
0.25(6%) = 9%. The expected return on the bond portfolio is 0.6(10%) + 0.4(7.5%) = 9%.
b. If you are risk-averse and have to choose between the stock and the bond investments,
which should you choose? Why?
In choosing between the stock or bond portfolio, they both have the same expected return.
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
supply curve Bs to the right. The result is that the intersection of the supply and demand
22. Usin
g
f
ram
e
and
f
In th
e
publ
i
have
B
s
) s
h
a
u
u
i
s
s
g
both the li
q
e
work, sho
w
f
alling durin
g
e
bond fram
e
i
c’s income
a
more att
r
ac
t
h
ift to the ri
g
q
uidity pref
e
w
why intere
s
g
recession
s
e
work, whe
n
a
nd wealth
r
t
ive invest
m
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ht (shown i
e
rence fram
e
s
t rates are
p
s
).
n
the econo
m
r
ises while t
h
m
ent opportu
n
n graph bel
o
e
work and t
h
p
rocyclical
(
m
y booms, t
h
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e supply o
f
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ities. Both
t
o
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s
h
e supply a
n
(
rising when
h
e demand
f
f
bonds also
i
t
he supply
a
s
indicated i
n
n
d demand f
o
the econo
m
f
or bonds in
c
increases, b
e
a
nd demand
c
n
the text, th
e
o
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m
y is expand
i
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reases. The
e
cause firm
s
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urves (B
d
a
e
demand c
u
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ng
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a
nd
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rve
23. Usin
g
inter
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f
ram
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In th
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for b
o
24. The
are
r
B
B
B
Q
Q
a
4
4
a.
W
S
–
b.
G
25. The
d
are r
e
B
d:
P
B
g
both the s
up
e
st rates are
e
works?
e
bond supp
l
o
nds. The d
e
demand cu
r
r
epresented
W
hat is the e
x
olving for t
h
0.6 Quantit
y
G
iven your a
n
d
emand cur
v
e
presented
b
P
rice = í 0
.
up
ply and de
m
affected wh
e
l
y and dema
n
e
mand curve
r
ve and sup
p
by the follo
w
x
pected equ
i
h
e equilibri
u
y
+ 1140 =
Q
n
swer to pa
r
v
e and supp
ly
b
y the follo
w
.
6 * Quanti
t
m
and for bo
n
e
n the riskin
e
n
d analysis,
t
B
d
shifts to
t
p
ly curve for
w
ing equati
o
i
librium pri
c
u
m gives:
Q
uantity + 7
0
r
t (a), what
i
y
curve for
o
w
ing equatio
n
t
y + 1140
n
ds and liqu
e
ss of bonds
t
he increase
d
t
he left, and
one-year di
s
o
ns:
c
e and quan
t
0
0;
i
s the expec
t
o
ne-year dis
n
s
idity prefer
e
rises. Are t
h
d
riskiness o
f
the equilibr
i
s
count bon
d
t
ity of bond
s
t
ed interest
r
count bond
s
e
nce framew
o
h
e results th
e
f
bonds low
e
i
um interest
r
d
s with a fac
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s
in this mar
k
r
ate in this
m
s
with a face
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e
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rs the dema
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r
ate rises. T
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value of $
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et?
m
arket?
e
value of $1
,
h
ow
e
two
n
d
h
e
1
,000
,
000
Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 88
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?
The monetary policy action, essentially an open market operation, increases the supply of
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?
In 2017:Q1, net worth increased by 8.3% from 2016:Q1. Holding everything else
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.
Over the same time period, the yield on the 10-year treasury increased from 1.92% to
2.26%, which is inconsistent with the answer in part (a). It is likely that there are many
2. Go t
o
(M1
S
the u
n
adju
s
a.
C
r
a
t
h
t
h
l
i
S
b.
R
i
n
g
r
e
i
n
e
f
S
n
n
e
i
h
e
i
y
6
e
6
e
s
s
i
i
o
the St. Lou
S
L) and the
1
n
its setting
t
s
t the freque
n
C
reate a sca
t
a
te on the v
e
h
e scatter pl
o
h
is; howeve
r
i
ne, are the
d
ee scatterpl
o
R
epeat part
(
n
terest rate
f
r
owth from
2
e
cent pairw
i
n
terpret the
l
f
fects.
ee scatterpl
o
is Federal
R
1
0-year U.S.
t
o “Percent
n
cy setting
t
t
ter plot, wit
h
e
rtical axis,
f
o
t, graph a
f
r
, one partic
u
d
ata consist
e
o
t below. Y
e
(a
), but this
t
f
our quarter
s
2
000:Q1 wi
t
i
se data ava
i
l
iquidity eff
e
o
t below. T
h
R
eserve FR
E
treasury b
o
Change fro
m
t
o “Quarter
ly
h
money gr
o
f
rom 2000:
Q
f
itted (regre
s
u
lar chart l
a
e
nt with the
l
e
s, the liqui
d
t
ime compa
r
s
later. For
e
t
h the intere
s
i
lable. Com
p
e
ct as it rela
t
h
e effects of
E
D database,
o
nd rate. Fo
r
m
Year Ago,
ly
.” Downlo
a
o
wth on the
h
Q
1 to the m
o
s
sion) line o
f
a
yout has th
i
l
iquidity eff
e
d
ity effect is
r
e the conte
m
e
xample, cr
e
s
t rate from
p
are your re
s
t
es to the in
c
money gro
w
,
and find d
a
r
the M1 mo
n
” and for th
e
a
d the data
i
h
orizontal a
x
o
st recent qu
f
the data (t
h
i
s option bu
i
e
ct? Briefly
e
clearly de
m
m
poraneous
e
ate a scatt
e
2001:Q1, a
n
s
ults to thos
c
ome, price
–
w
th one year
a
ta on the
M
ney supply
i
e
10-year tr
e
i
nto a sprea
d
x
is and the
1
arter of dat
a
h
ere are se
v
i
lt in). Base
d
e
xplain.
m
onstrated.
A
money gro
w
e
r plot comp
n
d so on, u
p
s
e obtained i
–
level, and e
x
later still s
e
M
1 money su
p
i
ndicator, a
dj
e
asury bon
d
d
sheet.
1
0-year trea
s
a
available.
v
eral ways t
o
d
on the fitte
d
A
s money gr
o
w
th rate wit
h
aring mone
y
p
to the most
n part (a),
a
x
pected-infl
a
e
em to indic
a
p
ply
dj
ust
d
,
s
ury
On
o
do
d
o
wth
h
the
y
a
nd
a
tion
a
te
Mishkin •
q
u
c.
R
w
m
m
i
n
o
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a
f
w
m
w
e
m
a
e
f
a
i
s
h
r
t
r
t
I
nstructor’s Ma
n
u
arter as in
(
R
epeat part
(
w
ith the inte
r
m
oney growt
h
m
ost recent
p
n
corporated
v
erall effect
ee scatterpl
o
f
ter two yea
r
n
ual for The Ec
o
(
a) above, b
u
(a
) again, ex
c
r
est rate eig
h
h
from 200
0
p
airwise dat
a
into the bo
n
of money g
r
o
t below. A
s
r
s suggest t
h
o
nomics of Mon
e
u
t it was lo
w
c
ept this ti
m
h
t quarters l
a
:Q1 with th
e
a
available.
A
n
d market a
f
r
owth on int
e
s
suming all
t
h
at a one pe
r
e
y, Banking, an
d
w
ered by onl
y
m
e compare
t
a
ter. For ex
a
e
interest ra
t
A
ssuming t
h
ft
er two yea
r
e
rest rates?
t
he effects r
u
r
centage poi
n
d
Financial Mar
k
y 14 basis p
t
he contemp
o
a
mple, crea
t
t
e from 200
2
h
e liquidity
a
r
s, what do
y
u
n its cours
e
n
t increase i
n
k
ets, Twelfth E
d
oints one y
e
o
raneous m
o
t
e a scatter
p
2
:Q1, and s
o
a
nd other ef
f
y
our results
i
e
after two y
e
n
money gr
o
d
ition
e
ar later, the
n
o
ney growth
p
lot compar
i
o
on, up to t
h
f
ects are ful
ly
i
mply about
e
ars, the dat
a
o
wth, on av
e
90
n
the
rate
i
ng
h
e
ly
the
a
e
rage,
i
i
i
i
e
e
Mishkin •
d.
B
a
n
I
nstructor’s Ma
n
B
ased on yo
u
n
d interest
r
n
ual for The Ec
o
u
r answers t
o
r
ates compa
r
o
nomics of Mon
e
o
parts (a) t
h
r
e to the thr
e
e
y, Banking, an
d
h
rough (c),
h
e
e scenario
s
d
Financial Mar
k
h
ow do the
a
s
presented i
n
k
ets, Twelfth E
d
a
ctual data
o
n
Figure 11
d
ition
o
n money gr
o
of this cha
p
91
o
wth
p
ter?