ECON530: Money and Banking Homework 3 Due: Feb. 12th Instructions: Provide concise answers to the following questions. Credit given is based on the accuracy and completeness of your answers. Show all the necessary calculations. 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. d) You expect gold to appreciate in value. e) Prices in the bond market become more volatile. 2. 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. b) You expect a bear market in stocks (stock prices are expected to decline). c) Brokerage commissions on stocks falls. d) You expect interest rates to rise. e) Brokerage commissions on bonds fall. 3. The demand and supply for one-year discount bonds with a face value of $1,000 are given below where P is the bond price and W , investors’ wealth.

Qd 
a) b) c) d) e)

6100 5 1  P  W and Q s  P  600 3 3 6

Find the equilibrium bond price as a function wealth. Find the equilibrium quantity as a function of wealth. Find the equilibrium interest rate as a function of wealth. All else equal, if wealth increases, what happens to the interest rate? Why. Suppose that this bond is currently trading at P  $960 . Assume that W  0 do we have excess demand or excess supply in market? Find Q d  Q s as a function of wealth.

4. 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? 5. How might a sudden increase in people’s expectations of future real estate prices affect interest rates? 6. Using both the supply and demand for bonds and liquidity preference frameworks, show what the effect is on interest rates when the riskiness of bonds rises. Are the results the same in the two frameworks? 7. Using the liquidity preference framework, show why interest rates are procylical (rising when the economy is expanding and falling during recessions).

8. 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. 9. Predict what will happen to interest rates if the public suddenly expects a large increase in stock prices. 10. Predict what will happen to interest rates if prices in the bond market become more volatile. 11. What effect will a sudden increase in the volatility of gold prices have on interest rates?