Clara Rodriguez Assignment 1 1 Assignment

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
1

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?

PV =

= 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: 2200 = + , 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 = 9.00 % = = 0.090002 =

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

Depending on whether the Bond market: description of a supply or demand curve shifts Price of bonds, P Booming economy and government more to the right the equilibrium 1000 deficit interest rate can rise or fall. i= 0 However, data indicates that the 5.3 interest rate is procyclical; it 800 rises during economic 17.6 expansions and falls during recessions (Mishkin, 108). During a recession income and 33.0% wealth decrease, as a result 600 there is an inward shift of the Quantity of bonds, B demand curve for bonds. This ($ Billions) 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

Keynes Liquidity Preference Framework: determines interest rate in terms of supply and demand for money

Equilibrium in the Money Market Interest rate, I (%)

30 25 20 15 10 5

= 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

= an increase in income will shift the demand curve outward to

= lower level of income shifts demand curve 0 100 200 300 400 500 600 Quantity of money (billions), M

= - 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

8. Explain what effect a large federal deficit might have on interest rates. Provide figure to illustrate your answer. Interest rate
0 5.3
800

Price of bonds, P 10000

17.6
60

33.0%

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

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.

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 ( ).

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 from . The result in the equilibrium bond prices is a
5

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 and .

Price

Price

Risk premium

Quantity of corporate bonds, B ($ Corporate bonds Billions)

Quantity of Treasury bonds, B ($ Billions) FIGURE 4

Treasury Bonds

10. If expectations of the inflation rate increase, what would you expect to happen to the shape of the yield curve? Why?

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.