Clara Rodriguez
Assignment 1
Assignment 1
1. Because there is an imbalance of information in a lending situation, we must deal with the
problems of adverse selection and moral hazard. Define these terms and explain how financial
intermediaries can reduce these problems.
Definitions:
Adverse selection- this is a condition which acknowledges that people with more risky
project are more likely to ask for loans and there is an information asymmetry present.
To reduce the risks associated with adverse selection risk evaluation needs to be as
accurate as possible and screening for services successful.
Moral hazard- this refers to a situation where one party is more informed than the other
party. This can be applied to a loan; the bank is not sure whether the money will be
used for what the loan intends, only the borrower will be mindful of the purpose for the
loan, and therefore has an a symmetrical information advantage over the lender. This
problem can be reduced by limiting the amount of risk associated with lending
agreements from the perspective of the lender and borrower, ensuring that the
borrowed funds not be used recklessly.
2. Which of the following three expressions uses the economists; definition of money? Provide
an explanation,
- “How much money did you earn last week?
- “when I go to the store, I always make sure I have enough money”
- The love of money is the root of all evil
Economists define money as anything that is accepted as a means of payment for goods
and services, or in the repayment of debt (Mishkin, 49). The second statement listed
above references payment for goods and services, which is the inherent condition for
the given definition. The first and third statements listed reference money in a
figurative existence. The first option references a rough quantitative number, which
generally would ignore the benefits from the health insurance and company picnic and
the third statement refers to behavior as a result of fantasy.
3. For each of the following assets, indicate which of the money aggregates (M1 and M2)
includes them:
- Currency- M1
- Money market and mutual funds- M2
-Small denomination time deposits- M2
- Checkable deposits- M1
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4. If the interest rate is 5%, what is the present value of a security that pays you $1,050 next
year and $1,102.50 two years from now, if this security is sold for $2200, is the yield to
maturity greater or less than 5%? Why?
1050
PV =(1.05) +
1,102.50
(1.05)2
= 2000.00
The yield to maturity equates the present value of cash flow payments received from a
debt instrument with its value today. The yield to maturity is greater than 5% because
the present value of the cash flows ($2000) is less than the sale price ($2200).
I think this is incorrect:
1050 1,102.50
2200 = (1+𝑖) + (1+𝑖)2 , i= negative??
The yield to maturity is less than five percent.
5. Assume you just deposited $1,000 into a bank account. The current real interest rate is 2%
and inflation is expected to be 6% over the next year. What nominal interest rate would you
require from the bank over the next year? How much money will you have at the end of the
year?
The fisher equation states that nominal interest rate equals real interest rate plus
inflation. This would lead to a required 8% nominal interest rate and a yearend balance of
$1,080.00.
6. A 10-year, 7% coupon bond with a face value of $1,000 is currently selling for $871.65.
Compute your rate of return if you sell the bond next year for $880.10.
In general, return = R =
Coupon+𝑃𝑡+1 (𝑠𝑎𝑙𝑒) − 𝑃𝑡
𝑝𝑡
=
70.+ 880.10 − 871.65
871.65
= 0.090002 = 9.00 %
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7. Using both the liquidity preference framework and the supply and demand for bonds
frameworks, show why interest rates are procyclical (rising when the economy is expanding
and falling during recession). Provide a figure(s) to illustrate you answer.
SUPPLY AND DEMAND FOR BONDS FRAMEWORK: determines interest rate in
terms of the supply and demand of bonds
Bond market: description of a Booming
Price of bonds, P economy and government deficit
1000
𝐵𝑠1
i=
0
𝐵𝑠2
5.3
800
17.6
𝑃1
𝑃2
600
33.0%
𝐵𝑑1
𝐵𝑑2
Quantity of bonds, B
($ Billions)
Depending on whether the supply or
demand curve shifts more to the right
the equilibrium interest rate can rise or
fall. However, data indicates that the
interest rate is procyclical; it rises during
economic expansions and falls during
recessions (Mishkin, 108).
During a recession income and wealth
decrease, as a result there is an inward
shift of the demand curve for bonds.
This shift results in an increase in interest
rates. When the economy is booming
there is an increase in the demand for
bonds. This increase in bond demand
shifts the demand right from 𝑃1 to 𝑃2 ,
this shift will increase the interest rate.
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Keynes’ Liquidity Preference Framework: determines interest rate in terms
of supply and demand for money
= opportunity cost of
spending money is higher,
the quantity of money
demanded is low as a
result of higher interest
rates
= market clearing point
interest rate = 15% and
money supply is 400
Equilibrium in the Money Market
Interest rate, I (%)
𝑀𝑠
30
25
20
15
10
𝑴𝒅𝟏
5
𝑴𝒅𝟐
0
100
200
300
𝑴
𝒅
= an increase in income
will shift the demand curve
outward to 𝑀𝑑1
= lower level of income
shifts demand curve inwards
to 𝑀𝑑2
400
500 600
Quantity of money (billions), M
𝐵 𝑠 + 𝑀 𝑠 = 𝑀𝑑 + 𝑀 𝑠 - Equation 1
Equation 1 says that if the money market is in equilibrium the bond market is also in equilibrium.
Fluctuations in economic conditions will affect the financial market conditions changing the
location of supply and demand curves for money. Applying the concept of opportunity cost, the
quantity of money demanded and the interest rate should be negatively related. During a
recession there is a decrease in income and during economic expansion there is an increase in
income. The income effect states that a lower level of income causes the demand for money at
each interest rate to increase and the money demand curve to shift to the right. Conversely, a
rise in income increases the demand transactions involving money and increase in the demand
for money for people to hold. These situations result in an outward shift in demand for money at
each interest rate. The central bank controls the money supply, so the supply curve for money is
vertical. Increasing the money supply will lower the interest rate. Examples of monetary
expansion include: Jimmy Carter Economic stimulus, Reagan, Busℎ2 (both President Bush’s).
*Obama is planning to increase the money supply with a stimulus package as well.
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8. Explain what effect a large federal deficit might have on interest rates. Provide figure to
illustrate your answer.
Interest
rate
Price of bonds, P
10000
0
𝑩𝒔𝟏
5.3
𝑩𝒔𝟐
800
17.6
𝑃1
𝑃2
60
33.0%
𝐵𝑑1
Quantity of bonds, B
($ Billions)
The government budget influences
the supply of bonds. When the
government has a large deficit, the
Treasury sells more bonds and the
supply curve will shift right. When
the bond curve shifts outward the
price falls. Because of the known
inverse relationship between
interest rates and bond prices the
new supply curve will result in
lower interest rates.
9. The spread between the interest rates on Baa corporate bonds and US government bonds is
very large during the Great depression years 1930-33. Explain this difference using the bond
supply and demand analysis. Provide an illustration.
*please see figure 4 on the following page.
T
he spread between Baa corporate bonds and US Government bonds is very large during
the Great Depression Years 1930-33. This difference in the spread can be explained by
the following factors: Risk Premium, Default risk, and Liquidity of the bond. During the
depression there was a very high rate of business failures. These failures increased the risk
premium and default risk of the bonds issued by corporations. If the possibility of default
increases for corporate bonds the default risk will increase, and the expected returns on these
bonds will decrease. Everything else equal this will result in a fall in demand for corporate
bonds (𝐷1𝑐 𝑡𝑜 𝐷2𝑐 ). At the same time, Treasury bonds which will be substituted because of
decreased risk for the less risky Treasury bonds, shifting the Treasury bond demand curve
from𝐷1𝑇 𝑡𝑜 𝐷2𝑇 . The result in the equilibrium bond prices is a rise in price for treasury bonds and
decrease in price for corporate bonds. Because of the inverse relationship between bond prices
and interest rates the interest rate for Treasury bonds will decrease and the interest rate
corporate bonds will increase. US Treasury bonds are the most liquid of all long-term bonds.
This will make them the most predictable investment during economic turbulence. There has
never been a default on Treasury bonds, which limits the default risk and affects the interest
rate. Notice the difference between 𝑖2𝑇 and 𝑖2𝑐 .
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Price
𝑃1𝑐
𝑆𝑇
Price
𝑆𝑐
𝑖2𝑇
Risk premium
𝑃2𝑐
𝑃2𝑇
𝑃1𝑇
𝑖2𝑐
𝐷1𝑐
𝐷2𝑐
Quantity of corporate bonds, B
($ Billions)
Corporate bonds
𝐷1𝑇
𝐷2𝑇
Quantity of Treasury bonds, B
($ Billions)
Treasury Bonds
FIGURE 4
10. If expectations of the inflation rate increase, what would you expect to happen to the shape
of the yield curve? Why?
I
f the expected inflation increases the yield curve will become inverted. Inflation is an overall increase
in the price of goods and services. Increasing the price level increases the interest rate and
increasing the supply of bonds increases the interest rate. The expected inflation will increase affect
the short-term nominal interest rate. As a result the short-term interest rate exceeds the long-term
interest rate the yield curve will be inverted.
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