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Q2 and Q4 of Assignment 2.
Q2, Q3, Q4 of Assignment 3

Econ 331: Money and Financial Institutions
Assignment #3

Spring 2021

This assignment is due via Blackboard (not via email) at 12:00pm (noon) on Friday February 19.
For all questions, the process of how you arrive at an answer is as important as the answer itself. For
full credit, you are therefore required to show all steps and work, clearly label graphs, and fully explain
any answers that ask for an explanation.

You can type your answers or write them by hand and scan them using the camera on your phone/tablet.
In either case, submit the file as a single pdf document. If you type your answers, it is important to
save as a pdf before submitting โ€“ equations often get jumbled between computers.

1. The demand curve and supply curve for one-year discount bonds with a face value of $1,000 are

represented by the following equations.
๐ต”: ๐‘ƒ๐‘Ÿ๐‘–๐‘๐‘’ = โˆ’0.6 โˆ— ๐‘„๐‘ข๐‘Ž๐‘›๐‘ก๐‘–๐‘ก๐‘ฆ + 1140

๐ต9: ๐‘ƒ๐‘Ÿ๐‘–๐‘๐‘’ = ๐‘„๐‘ข๐‘Ž๐‘›๐‘ก๐‘–๐‘ก๐‘ฆ + 700
What is the equilibrium interest rate?

2. Use the graphical bond market model to answer the following questions. In each case, support your
answer with a figure, and explain your answer. Label ach figure clearly.

a. What is the effect of an increase in wealth on interest rates?
b. What is the effect of a decrease in expected inflation on interest rates?
c. Why does an expectation of an upcoming interest rate hike by the Federal Reserve cause

bond prices to fall?

3. In 2010 and 2011, the government of Greece risked defaulting on its debt due to a severe budget

crisis. Set up one bond market graph for U.S. Treasury bonds, and a second bond market graph
for comparable-maturity Greek debt. Use these graphs to show the effects on (a) the interest rate
on U.S. Treasury bonds, and (b) on the interest rate on Greek bonds. Explain your answer.
(Clearly label your figures: first set up the initial equilibrium, and then clearly label all shifts).

4. In this question, you will look at the spread between riskless and risky bonds over time by

comparing the riskless rate on 10-year Treasury bonds to (riskier) 10-year Baa corporate bonds
using FRED.

a. Go to the FRED website, and search for the โ€œ10-year Treasury constant maturity rateโ€.
Select monthly data. Go to edit graph, and add a line describing โ€œMoodyโ€™s 10-year
seasoned Baa corporate bond yieldโ€. Change the dates, so youโ€™re looking at 2002 to the
present. Download the graph and submit with your assignment.

b. Letโ€™s look at the same data a different way. Specifically, look at the credit spread (the
yield on Baa bonds relative to Treasuries). In a new window, search for โ€œMoodyโ€™s
seasoned Baa corporate bond yield relative to yield on 10-year Treasury constant
maturityโ€. Again, use monthly data and show 2002 to the present.

c. Describe your graph (2-3 sentences). In your description, address:
i. The relative levels of the two series over time.

ii. What happened to the credit spread (the return on riskier bonds โ€“ i.e. Baa
corporate bonds โ€“ relative to less risky securities โ€“ i.e. Treasuries) during the
crisis.

1

Econ 331: Money and Financial Institutions
Assignment #2

Spring 2021

This assignment is due via Blackboard (not via email) at 12:00pm (noon) on Friday February 5.
For all questions, the process of how you arrive at an answer is as important as the answer itself. For
full credit, you are therefore required to show all steps and work, clearly label graphs, and fully explain
any answers that ask for an explanation.

You can type your answers or write them by hand and scan them using the camera on your phone/tablet.
In either case, submit the file as a single pdf document. If you type your answers, it is important to
save as a pdf before submitting โ€“ equations often get jumbled between computers.

1. Suppose you want to take out a loan and your local bank wants to charge you an interest rate of

3%.
a. Assuming the annualized expected rate of inflation over the life of the bond is 1%, what

is the nominal interest rate that the bank will charge you?
b. Will you be better or worse off if actual inflation turns out to be 0.5%?
c. Will the bank be better or worse off if actual inflation turns out to be 0.5%?

2. Explain in one sentence each why you would be more or less willing to buy bonds in each of the

following circumstances. (Link your explanation to the main determinants of asset demand we
discussed in the model).

a. You expect Microsoft stock to double in value next year.
b. Prices in the stock market become more volatile.
c. You just inherited $100,000.
d. You expect housing prices to fall.
e. You expect the stock market to appreciate in value.

3. Suppose and you are considering investing some of your wealth in stocks, bonds or commodities.

The following table 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 7.5% 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?
b. If you are risk averse and have to choose between the stock and bond investments, which

one should you choose? Why?

4. Use the graphical bond market model to answer the following questions. In each case, support your

answer with a figure, and explain briefly.
a. What is the effect of a decrease in expected inflation on interest rates?
b. Why does an expectation of an upcoming interest rate hike by the Federal Reserve cause

bond prices to fall?

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