Ans wers are due onM arch 13t h, 2007

Econ216 TAKE- HOM EQUI Z3

W hen t he price of t he bond i ncreases, the i nt erest rate falls.

Pr obl em 1
Suppose t hat a persons yearl y no
m inal i nco
m eis $50, 000. Al so suppose t hat herm oney dem and

E. g. Consi der an expansi onar y openm arket operati on where t he Central Bank purchases bonds,

functi on is given by

and pays for them by creatingm oney.

d

M = PY( 0. 25 i)
(a)W hat is her dem and form oney when t he i nt erest rat e is %
5 ?
M d = PY( 0. 25 i)

(1)

Dem

(2)

Suppl y ofm noey i n t he econo

m

and for bonds i ncreases and pri ce of bonds i ncreases

(3)

As a result, we see a fall i n i nt erest rat e; bonds beco

m e l ess attractive andm oney

yincreases.

M d = 50000 (0. 25 0. 05)

bal ances becom em ore attracti ve. Dm

e and form oney increases and equili bri m
u in

M d = $10, 000

t hem oneym ar ket ism aintai ned.

(b) Suppose that t he i nt erest rat e is %

5 .In percent age term s, what happens t o her dem and for

m oney if her yearl y i nco

m e is reduced by 50
% ?

If yearl y i ncom eis reduced t o $25, 000, ne wm oney dem and:

M d = PY( 0. 25 i)
M d = 25000 (0. 25 0. 05)

M = $5, 000

Dem

and for m oney falls by 50

%

Pr obl em 2

=PYL(i)
M

A bond pr om ises t o pay 100 i n one year

(a)W hat is t he i nt erest rat e on t he bond if its pri ce t oday is 75? 85? 95?

(c) If t he i nterest rat e is 8% , what is t he pri ce of t he bond t oday?

100
1+ i
100
P =
1 + 0.08
P = 92.6
P =
B

P =
B

i =

100
1+ i

100
1
PB

i =33. 33
% , 17. 6% , 5. 26% when PB = 75, 85, 95 respecti vel y.
(b)W hat is t he rel ati on between t he pri ce of t he bond and t he i nt erest rat e? Consider an exam lpe
of CB usi ng openm arket purchase. Descri be how t his purchase affects bot h prices of bonds and
i nt erest rat e.