TUTORIAL 2

MONEY AND INTEREST RATES

I. Review questions
1. Explain money definition and functions of money and how to measure money.
2. Distinguish major credit types, provide examples
3. Explain the relationship between YTM and bond prices
4. Distinguish yield to maturity and rate of returns

II. Multiple-choice questions

1. Which of these is not a function of money in an economy?
A. Unit of account
B. Source of income
C. Store of value
D. Medium of exchange

2. Which of the following is not part of M1?

A. traveler's checks
B. savings accounts
C. checking accounts
D. currency

3. If Mary deposits $100 of her currency in her checking account, then:

A. M2 will fall by $100.
B. M1 will increase by $100.
C. M1 and M2 will not change.
D. M2 will increase by $100.

4. If Mary moves $100 from her savings account to her checking account, then:
A. M2 will not change.
B. M2 will fall by $100.
C. M1 will not change.
D. M1 will fall by $100

5. Inefficiencies that are created when using checks as money include:

A. Checks can transfer funds slowly and require paper shuffling.
B. Checks can be written for any amount.
C. Checkbooks can be stolen.
D. There are too many bad checks written

6. The liquidity of an asset is:

A. the amount of an asset sold at discount or premium.
B. the ability of an asset to earn interest income.
C. the relative ease with which an asset can be converted into a medium of exchange.
 D. the relative ease with which an asset can be converted into a common stock.

7. As bond prices increase:

A. yields to maturity decrease.
B. yields to maturity increase.
C. yields to maturity can rise, fall, or not change.
D. yields to maturity do not change.

8. If a bond sells at a premium, where price exceeds face value, then we would expect to
see:
A. market interest rates could be the same, higher, or lower than the coupon rate.
B. market interest rate the same as the coupon rate.
C. market interest rates below the coupon rate.
D. market interest rates above the coupon rate.

9. For a $1000 one-year discount bond with a price of $975, the yield to maturity is
A. ($1000 – $975)/($1000)
B. $975/$1000
C. ($1000 – $975)/$975
D. $1000/$975

10. Interest rate risk is:

A. the risk the coupon rate on the bond will fall.
B. the risk the government or firm will not make interest payments.
C. the risk associated with change in return with changes in interest rates.
D. the risk the coupon payment will rise.

11. The real interest rate is:

A. the nominal rate plus the expected inflation rate.
B. the nominal interest rate/the CPI.
C. the product of the nominal rate and the CPI.
D. the nominal rate minus the expected inflation rate

12. For a coupon bond, the yield to maturity is the:

A. difference between the bond's price and its face value.
B. annual interest payment divided by the bond's face value.
C. interest rate that equates the bond's present value with its price.
D. interest rate that equates the bond's present value with its face value.

13. When interest rates fluctuate, which bonds will experience the least price volatility?
A. 20-year bonds
B. 1-year bonds
C. 5-year bonds
D. 10-year bonds
14. Why is the Rate of Return often the most relevant measure of a bond's benefit to the
buyer?
A. Because the Rate of Return uses the current yield.
B. Because the Rate of Return includes the return of the face value at maturity.
C. Because the Rate of Return uses the difference between the face value and the
purchase price to compute a capital gain on the bond.
D. Because the Rate of Return recognizes that many bond buyers do not plan to hold to
maturity, but will sell the bond before maturity.

15. If the amount payable in two years is $2420 for a simple loan at 10 percent interest, the
loan amount is
A) $1000.
B) $1210.
C) $2000.
D) $2200.

16. If $22,050 is the amount payable in two years for a $20,000 simple loan made today, the
interest rate is
A) 5 percent.
B) 10 percent.
C) 22 percent.
D) 25 percent

17. If a security pays $110 next year and $121 the year after that, what is its yield to maturit
y if it sells for $200?
A) 9 percent
B) 10 percent
C) 11 percent
D) 12 percent
.
18. Which of the following $5,000 face-value securities has the highest yield to maturity?
A) A 6 percent coupon bond selling for $5,000 => 6
B) A 6 percent coupon bond selling for $5,500 => < 6
C) A 10 percent coupon bond selling for $5,000 => 10
D) A 12 percent coupon bond selling for $4,500 => >12

19. In which of the following situations would you prefer to be the lender?
A) The interest rate is 9 percent and the expected inflation rate is 7 percent.
B) The interest rate is 4 percent and the expected inflation rate is 1 percent.
C) The interest rate is 13 percent and the expected inflation rate is 15 percent.
D) The interest rate is 25 percent and the expected inflation rate is 50 percent.

20. In which of the following situations would you prefer to be the borrower?
A) The interest rate is 9 percent and the expected inflation rate is 7 percent.
B) The interest rate is 4 percent and the expected inflation rate is 1 percent.
C) The interest rate is 13 percent and the expected inflation rate is 15 percent.
D) The interest rate is 25 percent and the expected inflation rate is 50 percent.

III. Practice exercises

Questions taken and adapted from chapter 3 and chapter 4 (Mishkin, 2019)

1. Explain the concept of liquidity. Rank the following assets from most liquid to least liquid:
a. Land
b. The inventory of a merchandiser
c. Cash in hand => 1
d. A savings account at a local bank
e. A one-year bond
f. Ordinary shares

2. Which of the Federal Reserve’s measures of the monetary aggregates—M1 or M2—is

composed of the most liquid assets? Which is the larger measure?

3. For each of the following assets, indicate which of the monetary aggregates (M1 and M2)
includes them:
a. Currency
b. Money market mutual funds
c. Small-denomination time deposits
d. Checkable deposits

4. If mortgage rates rise from 5% to 10% but the expected rate of increase in housing prices rises
from 2% to 9%, are people more or less likely to buy houses?

5. If interest rates decline, which would you rather be holding, long-term bonds or short-term
bonds? Why? Which type of bond has the greater interest-rate risk?

6. Calculate the present value of a $1,300 discount bond with seven years to maturity if the yield
to maturity is 8%.

7. What is the yield to maturity on a simple loan sold for $1,500 that requires a repayment of
$15,000 in five years?

8. Consider a bond with a 6% annual coupon and a face value of $1,000. Complete the following
table. What relationships do you observe between years to maturity, yield to maturity, and the
current price?
Years to maturity Yield to maturity Current price
2 4%
2 6%
3 6%
5 4%
5 8%
9. A $1,100-face-value bond has a 5% coupon rate, its current price is $1,040, and it is expected
to increase to $1070 next year. Calculate the current yield, the expected rate of capital gains, and
the expected rate of return.

10. You have just purchased a 10-year, $1,000 par value bond. The coupon rate on this bond is 8
percent annually, with interest being paid each 6 months. If you expect to earn a 10 percent yield
on this bond, how much did you pay for it?

11. Callaghan Motors’ bonds have 10 years remaining to maturity. Interest is paid annually, they
have a $1,000 par value, the coupon interest rate is 8%, and the yield to maturity is 9%. What is
the bond’s current market price?

12. A bond has a $1,000 par value, 10 years to maturity, and a 7% annual coupon and sells for
$985.
a. What is its yield to maturity (YTM)?
b. Assume that the yield to maturity remains constant for the next 3 years. What will the price be
3 years from today?