Lesson 5-6: Behavior of Interest rates (Supply - Demand of Bond & Money Market)

1. If wealth increases, the demand for stocks ________ and that of long-term bonds
________, everything else held constant.
A) increases; increases
B) increases; decreases
C) decreases; decreases
D) decreases; increases
Answer: A

2. An increase in an assetʹs expected return relative to that of an alternative asset, holding

everything else constant, ________ the quantity demanded of the asset.
A) increases
B) decreases
C) has no effect on
D) erases
Answer: A

3. The demand for gold increases, other things equal, when

A) the market for silver becomes more liquid.
B) interest rates are expected to rise.
C) interest rates are expected to fall.
D) real estate prices are expected to increase.
Answer: B

4. During business cycle expansions when income and wealth are rising, the demand for
bonds________ and the demand curve shifts to the ________, everything else held
constant.
A) falls; right
B) falls; left
C) rises; right

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D) rises; left
Answer: C

5. Everything else held constant, if interest rates are expected to fall in the future, the
demand for long-term bonds today ________ and the demand curve shifts to the ________.
A) rises; right
B) rises; left
C) falls; right
D) falls; left

6. Everything else held constant, an increase in the riskiness of bonds relative to alternative
assets causes the demand for bonds to ________ and the demand curve to shift to the
________.
A) rise; right
B) rise; left
C) fall; right
D) fall; left
Answer: D

7. Factors that decrease the demand for bonds include

A) an increase in the volatility of stock prices.
B) a decrease in the expected returns on stocks.
C) a decrease in the inflation rate.
D) a decrease in the riskiness of stocks.
Answer: D

8. In a business cycle expansion, the ________ of bonds increases and the ________ curve
shifts to the ________ as business investments are expected to be more profitable.
A) supply; supply; right
B) supply; supply; left
C) demand; demand; right

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D) demand; demand; left
Answer: A

9. Higher government deficits ________ the supply of bonds and shift the supply curve to
the________, everything else held constant.
A) increase; left
B) increase; right
C) decrease; left
D) decrease; right
Answer: B

10. When the economy slips into a recession, normally the demand for bonds ________, the
supply of bonds ________, and the interest rate ________, everything else held constant.
A) increases; increases; rises
B) decreases; decreases; falls
C) increases; decreases; falls
D) decreases; increases; rises
Answer: B

11. When the interest rate changes,

A) the demand curve for bonds shifts to the right.
B) the demand curve for bonds shifts to the left.
C) the supply curve for bonds shifts to the right.
D) it is because either the demand or the supply curve has shifted.
Answer: D

12. If people expect real estate prices to increase significantly, the ________ curve for bonds
will shift to the ________, everything else held constant.
A) demand; right
B) demand; left

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C) supply; left
D) supply; right
Answer: B

13. In the figure above, a factor that

could cause the supply of bonds to shift to the right is:
A) a decrease in government budget deficits.
B) a decrease in expected inflation.
C) a recession.
D) a business cycle expansion.
Answer: D

14. In Keynesʹs liquidity preference framework,

A) the demand for bonds must equal the supply of money.
B) the demand for money must equal the supply of bonds.
C) an excess demand of bonds implies an excess demand for money.
D) an excess supply of bonds implies an excess demand for money.
Answer: D

15. The bond supply and demand framework is easier to use when analyzing the effects of
changes in ________, while the liquidity preference framework provides a simpler analysis
of the effects from changes in income, the price level, and the supply of ________.
A) expected inflation; bonds
B) expected inflation; money and income
C) government budget deficits; bonds
D) government budget deficits; money and income
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Answer: B

16. An increase in the interest rate

A) increases the demand for money.
B) increases the quantity of money demanded.
C) decreases the demand for money.
D) decreases the quantity of money demanded.
Answer: D

17. In the Keynesian liquidity preference framework, an increase in the interest rate causes
the demand curve for money to ________, everything else held constant.
A) shift right
B) shift left
C) stay where it is
D) invert
Answer: C

18. A rise in the price level causes the demand for money to ________ and the interest rate
to ________, everything else held constant.
A) decrease; decrease
B) decrease; increase
C) increase; decrease
D) increase; increase
Answer: D

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19. In the figure above, one factor not
responsible for the decline in the demand for money is
A) a decline the price level.
B) a decline in income.
C) an increase in income.
D) a decline in the expected inflation rate.
Answer: C

20. The figure above illustrates the effect of an

increased rate of money supply growth at time period T0. From the figure, one can conclude
that the
A) liquidity effect is smaller than the expected inflation effect and interest rates adjust
quicklyto changes in expected inflation.
B) liquidity effect is larger than the expected inflation effect and interest rates adjust quickly
to changes in expected inflation.
C) liquidity effect is larger than the expected inflation effect and interest rates adjust slowly
to changes in expected inflation.
D) liquidity effect is smaller than the expected inflation effect and interest rates adjust
slowly to changes in expected inflation.
Answer: D

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Lesson 7: The Risk and Term Structure of Interest Rates

1. The risk structure of interest rates is

A) the structure of how interest rates move over time.
B) the relationship among interest rates of different bonds with the same maturity.
C) the relationship among the term to maturity of different bonds.
D) the relationship among interest rates on bonds with different maturities.
Answer: B

2. The risk that interest payments will not be made, or that the face value of a bond is not
repaid
when a bond matures is
A) interest rate risk.
B) inflation risk.
C) moral hazard.
D) default risk.
Answer: D

3. Which of the following bonds are considered to be default-risk free?

A) Municipal bonds
B) Investment-grade bonds
C) U.S. Treasury bonds
D) Junk bonds
Answer: C

4. If the probability of a bond default increases because corporations begin to suffer large
losses, then the default risk on corporate bonds will ________ and the expected return on
these bonds will ________, everything else held constant.
A) decrease; increase
B) decrease; decrease

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C) increase; increase
D) increase; decrease
Answer: D

5. Which of the following statements are true?

A) A decrease in default risk on corporate bonds lowers the demand for these bonds, but
increases the demand for default-free bonds.
B) The expected return on corporate bonds decreases as default risk increases.
C) A corporate bondʹs return becomes less uncertain as default risk increases.
D) As their relative riskiness increases, the expected return on corporate bonds increases
relative to the expected return on default-free bonds.
Answer: B

6. Which of the following statements are true?

A) A decrease in default risk on corporate bonds lowers the demand for these bonds, but
increases the demand for default-free bonds.
B) The expected return on corporate bonds decreases as default risk increases.
C) A corporate bondʹs return becomes less uncertain as default risk increases.
D) As their relative riskiness increases, the expected return on corporate bonds increases
relative to the expected return on default-free bonds.
Answer: B

7. When the Treasury bond market becomes more liquid, other things equal, the demand
curve for
corporate bonds shifts to the ________ and the demand curve for Treasury bonds shifts to
the
________.
A) right; right
B) right; left
C) left; right

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D) left; left
Answer: C

8. Everything else held constant, if the tax-exempt status of municipal bonds were
eliminated, then
A) the interest rates on municipal bonds would still be less than the interest rate on
Treasury
bonds.
B) the interest rate on municipal bonds would equal the rate on Treasury bonds.
C) the interest rate on municipal bonds would exceed the rate on Treasury bonds.
D) the interest rates on municipal, Treasury, and corporate bonds would all increase.
Answer: C

9. Everything else held constant, an increase in marginal tax rates would likely have the
effect of ________ the demand for municipal bonds, and ________ the demand for U.S.
government
bonds.
A) increasing; increasing
B) increasing; decreasing
C) decreasing; increasing
D) decreasing; decreasing
Answer: B

10. The term structure of interest rates is

A) the relationship among interest rates of different bonds with the same maturity.
B) the structure of how interest rates move over time.
C) the relationship among the term to maturity of different bonds.
D) the relationship among interest rates on bonds with different maturities.
Answer: D

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11. A plot of the interest rates on default-free government bonds with different terms to
maturity is
called
A) a risk-structure curve.
B) a default-free curve.
C) a yield curve.
D) an interest-rate curve.
Answer: C

12. When yield curves are steeply upward sloping,

A) long-term interest rates are above short-term interest rates.
B) short-term interest rates are above long-term interest rates.
C) short-term interest rates are about the same as long-term interest rates.
D) medium-term interest rates are above both short-term and long-term interest rates.
Answer: A

13. An inverted yield curve

A) slopes up.
B) is flat.
C) slopes down.
D) has a U shape.
Answer: C

14. According to the expectations theory of the term structure, the interest rate on a long-
term bond will equal the ________ of the short-term interest rates that people expect to
occur over the life
of the long-term bond.
A) average
B) sum
C) difference

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D) multiple
Answer: A

15. If the expected path of one-year interest rates over the next five years is 4 percent, 5
percent, 7 percent, 8 percent, and 6 percent, then the expectations theory predicts that
todayʹs interest rate
on the five-year bond is
A) 4 percent.
B) 5 percent.
C) 6 percent.
D) 7 percent.
Answer: C

16. According to the expectations theory of the term structure

A) the interest rate on long-term bonds will exceed the average of short-term interest rates
that people expect to occur over the life of the long-term bonds, because of their
preference for short-term securities.
B) interest rates on bonds of different maturities move together over time.
C) buyers of bonds prefer short-term to long-term bonds.
D) buyers require an additional incentive to hold long-term bonds.
Answer: B

17. According to the segmented markets theory of the term structure

A) bonds of one maturity are close substitutes for bonds of other maturities, therefore,
interest
rates on bonds of different maturities move together over time.
B) the interest rate for each maturity bond is determined by supply and demand for that
maturity bond.
C) investorsʹ strong preferences for short-term relative to long-term bonds explains why
yield curves typically slope downward.

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D) because of the positive term premium, the yield curve will not be observed to be
downward-sloping.
Answer: B

18. The segmented markets theory can explain

A) why yield curves usually tend to slope upward.
B) why interest rates on bonds of different maturities tend to move together.
C) why yield curves tend to slope upward when short-term interest rates are low and to be
inverted when short-term interest rates are high.
D) why yield curves have been used to forecast business cycles.
Answer: A

19. According to the liquidity premium theory of the term structure

A) because buyers of bonds may prefer bonds of one maturity over another, interest rates
on
bonds of different maturities do not move together over time.
B) the interest rate on long-term bonds will equal an average of short-term interest rates
that people expect to occur over the life of the long-term bonds plus a term premium.
C) because of the positive term premium, the yield curve will not be observed to be
downward sloping.
D) the interest rate for each maturity bond is determined by supply and demand for that
maturity bond.
Answer: B

20. If 1-year interest rates for the next three years are expected to be 4, 2, and 3 percent,
and the 3-year term premium is 1 percent, than the 3-year bond rate will be
A) 1 percent.
B) 2 percent.
C) 3 percent.
D) 4 percent.

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Answer: D

21. If 1-year interest rates for the next three years are expected to be 4, 2, and 3 percent,
and the 3-year term premium is 1 percent, than the 3-year bond rate will be
A) 1 percent.
B) 2 percent.
C) 3 percent.
D) 4 percent.
Answer: D

22. According to this theory of the term structure, bonds of different maturities are not
substitutes for one another.
A) Segmented markets theory
B) Expectations theory
C) Liquidity premium theory
D) Separable markets theory
Answer: A

23. In actual practice, short-term interest rates and long-term interest rates usually move
together; this is the major shortcoming of the
A) segmented markets theory.
B) expectations theory.
C) liquidity premium theory.
D) separable markets theory.
Answer: A

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24. The U-shaped yield curve in the figure above indicates
that short-term interest rates are
expected to
A) rise in the near-term and fall later on.
B) fall sharply in the near-term and rise later on.
C) fall moderately in the near-term and rise later on.
D) remain unchanged in the near-term and rise later on.
Answer: B

25. When the yield curve is flat or downward-sloping, it suggest that the economy is more
likely to enter
A) a recession.
B) an expansion.
C) a boom time.
D) a period of increasing output.
Answer: A

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