Economics 230-01
Solution to Midterm Examination
Fall 1999
Part A:
1. D
11. D
21. D
2. E
12. B
22. E
3. A
13. C
23. C
4. A
14. D
24. E
5. C
15. E
25. A
6. B
16. C
26. B
7. C
17. D
27. B
8. E
18. A
28. B
9. C
19. E
29. C
10. A
20. A
30. D
Part B:
1.
unit of account
2.
underwriting; investment bankers
3.
Equity-premium puzzle (or some explanation of that puzzle)
4.
European Monetary Union or EMU
5.
Increase; medium of exchange; store of value (asset)
6.
Adverse selection risk; moral hazard risk
7.
Over-the-counter
8.
Not substitutable
9.
Liquidity effect
10.
Positive; inflation (or expected inflation)
11.
Interest rate risk
12.
Euro bond
13.
Ba (or BB)
14.
Default risk; liquidity risk
Part C:
Question 1:
This question is the exact opposite of the example given in the textbook on 117-119.
a.
See Figure 7 on page 118 in your textbook.
b.
As income falls in a recession, demand for bond decreases, bond demand curve shifts to the left.
In a recession, there are fewer profitable (business) investment opportunities, thus supply of bond
falls, and bond supply curve shift to the left.
c.
Market interest rate may be higher, lower, or remain the same. Historically, however, interest
rates have fallen in a recession.
d.
At the new equilibrium, the equilibrium quantity of bond is lower.
Question 2:
a.
The key assumption in the Preferred Habitat Theory is that bonds of different maturities are
imperfect substitutes. In the Expectations Hypothesis, the key assumption is that bonds of
different maturities are perfect substitutes.
b.
For the Expectations Hypothesis, the yield on the long-term bond is an average of the current and
expected future yields of short-term bonds. This is also true for the Preferred Habitat Theory,
except that in addition, the Preferred Habitat Theory also assumes a non-constant term
(risk/liquidity) premium for the long-term bond.
c.
For the Preferred Habitat Theory a flat yield curve reflects the market’s expectations that future
short-term interest rates are going to decrease modestly. For the Expectations Hypothesis, a flat
yield curve means that the market expects future short-term interest rates to be the same as the
current short-term interest rate.