ECON 310 009 Money & Banking J. Scott Sperling
Problem Set 4 Answers
Due: February 28, 2002
1. Why does the bond supply curve slope up and the bond demand curve slope down in the bond market
diagram?
The bond supply curve slopes up because as prices increase, ceteris paribus, borrowers are more willing
to supply bonds (they can receive a higher price, lower interest rate). The bond demand curve slopes
down because as prices decrease (interest rates increase), lenders are more willing to purchase bonds, ceteris
paribus.
2. How does a change in household wealth affect the price of bonds, all other things being equal? (show a
graph as well)
People will demand more bonds, shifting the demand curve for bonds out (to the right). The price of bonds
increases (interest rates decrease).
3. Two countries that are alike in all other respects differ markedly in their provision of social insurance.
One country provides old-age retirement pensions, unemployment insurance, and catastrophic illness in-
surance; the other country provides no social insurance. What is your prediction about the difference in
interest rates in the two countries? Explain, using a graph.
The country which provides social insurance has relatively higher spending, ceteris paribus. If they raise
revenues by issuing bonds (increasing the bond supply), their interest rate should be higher relative to the
country which has no social insurance programs.
4. Most economists argue that a boom in the stock market is a sign that profitable business opportunities
are expected for the future. Describe the likely effects of such a boom on the bond supply and interest rates.
What assumptions did you make?
Assuming that bond demand does not respond as much as bond supply, businesses will take advantage
of increased profit expectations by increasing investment through bond financing. Therefore the supply of
bonds increases pushing up interest rates.
5. A yield curve shows the relationship between the market interest rates on bonds that are identical except
in what aspect?
term to maturity
6. When does the yield curve slope upward, according to the expectations theory? According to the
segmented markets theory? According to the liquidity premium theory?
According to the expectations theory, the yield curve is upward sloping when future short-term interest
rates are expected to increase (Likewise, when [current] short-term interst rates are low). According to the
segmented markets theory, the yield curve almost always slopes upward due the risk premium associated
with longer term bonds. According to the liquidity preference theory, the yield curve is almost always
upward sloping, again, due the risk and liquidity premium associated with longer term bonds.
7. During the late 1970s Michael Milken convinced many investors that the yields on junk bonds more
than compensated their higher default risk. What do you think happened to the liquidity of these bonds as
a result?
