TUTORIAL 3

THE BEHAVIOR OF INTEREST RATES

Part 1. Review questions

1. What are determinants of assets demand?
2. Loanable fund framework:
- Explain how the interest rate is determined;
- Distinguish movement and shift of demand and supply curves;
- Factors affecting interest rates.
3. Describe the liquidity preference framework:
- Demand for money;
- Supply of money;
- Change in equilibrium interest rate.

Part 2. Multiple-choice questions

1. If gold becomes acceptable as a medium of exchange, the demand for gold will
________ and the demand for bonds will ______, everything else held constant.
A) decrease; decrease
B) decrease; increase
C) increase; increase
D) increase; decrease

2. The demand curve for bonds has the usual downward slope, indicating that at
________ prices of the bond, everything else equal, the ________ is higher.
A) higher; demand
B) higher; quantity demanded
C) lower; demand
D) lower; quantity demanded

3. Everything else held constant, if the expected return on U.S. Treasury bonds falls
from 10 to 5 percent and the expected return on GE stock rises from 7 to 8 percent, then
the expected return of holding GE stock ________ relative to U.S. Treasury bonds and
the demand for GE stock ________.
A) rises; rises
B) rises; falls
C) falls; rises
D) falls; falls

4. An increase in the expected rate of inflation will ________ the expected return on
bonds relative to the that on ________ assets, everything else held constant.
A) reduce; financial
B) reduce; real
C) raise; financial
D) raise; real

5. The theory of asset demand tells us that

A) The demand for an asset will increase if the expected return on an asset rises.
B) Risky assets have higher liquidity.
C) Risky assets bring higher returns.
D) The higher the return on an asset, the lower the liquidity.

6. At a bond price above the equilibrium

A) there is an excess supply and the price will tend to fall.
B) there is an excess demand and the price will tend to rise.
C) there is an excess demand and the price will tend to fall.
D) there is an excess supply and the price will tend to rise.

7. Suppose the price of bond J rises. This will:

A) increase the supply of bond K and reduce the interest rate on bond K.
B) increase the demand for bond K and decrease the interest rate on bond K.
C) increase the demand for bond K and increase the interest rate on bond K.
D) increase the supply of bond K and increase the interest rate on bond K

8. Which of the following will increase the supply of bonds (shift the supply curve to
the right)?
A) A government budget surplus.
B) An increase in the bond prices.
C) A business cycle expansion.
D) A decrease in the expected inflation rate

9. At interest rates below the equilibrium rate of interest

A) there is an excess demand for money and the interest rate will rise.
B) there is an excess demand for bonds and the interest rate will fall.
C) there is an excess supply of bonds and the interest rate will fall.
D) there is an excess demand for money and the interest rate will fall.

10. Why does the supply curve for bonds slope upward?
A) Because as the price falls, firms are more willing to supply bonds.
B) Because as the interest rate falls, firms are more willing to borrow money.
C) Because as the price rises, firms are more willing to buy bonds.
D) Because as the interest rate rises, firms are more willing to borrow money

11. Increasing government deficits causes

A) The supply curve for bonds to shift right because government bonds pay higher interest
relative to other bonds
B) The supply curve for bonds to shift right because the U.S. Treasury will issue bonds to
pay for the deficit
C) The supply curve for bonds to shift left because government bonds slow expected
inflation
D) The supply curve for bonds to shift left because corporations will borrow less due to
decreased profitability when the government is in debt

12. When the price of a bond decreases, all else equal, the bond demand curve ________.
A) shifts right
B) shifts left
C) does not shift
D) inverts

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

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

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
C) government budget deficits; bonds
D) government budget deficits; money

16. In his Liquidity Preference Framework, Keynes assumed that money has a zero rate
of return; thus,
A) when interest rates rise, the expected return on money falls relative to the expected return
on bonds, causing the demand for money to fall.
B) when interest rates rise, the expected return on money falls relative to the expected return
on bonds, causing the demand for money to rise.
C) when interest rates fall, the expected return on money falls relative to the expected return
on bonds, causing the demand for money to fall.
D) when interest rates fall, the expected return on money falls relative to the expected return
on bonds, causing the demand for money to rise.

17. In Keynes's 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.

18. 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

19. When the price level ________, the demand curve for money shifts to the ________
and the interest rate ________, everything else held constant.
A) falls; left; falls
B) rises; right; falls
C) falls; left; rises
D) rises; right; rises

20. When the Fed ________ the money stock, the money supply curve shifts to the
________ and the interest rate ________, everything else held constant.
A) decreases; right; rises
B) increases; right; falls
C) decreases; left; falls
D) increases; left; rises

21. Of the four effects on interest rates from an increase in the money supply, the one
that works in the opposite direction of the other three is the
A) liquidity effect.
B) income effect.
C) price level effect.
D) expected inflation effect.

22. When the growth rate of the money supply increases, interest rates end up being
permanently lower if
A) the liquidity effect is larger than the other effects.
B) there is fast adjustment of expected inflation.
C) there is slow adjustment of expected inflation.
D) the expected inflation effect is larger than the liquidity effect.
23. If the liquidity effect is smaller than the other effects, and the adjustment to
expected inflation is immediate, then the
A) interest rate will fall.
B) interest rate will rise.
C) interest rate will fall immediately below the initial level when the money supply grows.
D) interest rate will rise immediately above the initial level when the money supply grows.

24. When the growth rate of the money supply is increased, interest rates will fall
immediately if the liquidity effect is _________ than the other money supply effects and
there is ________ adjustment of expected inflation.
A) larger; fast
B) larger; slow
C) smaller; slow
D) smaller; fast

25. In the figure above, illustrates the effect of an increased rate of money supply
growth at time period 0. From the figure, one can conclude that the
A) Liquidity effect is smaller than the expected inflation effect and interest rate adjusts
quickly to changes in expected inflation
B) Liquidity effect is larger than the expected inflation effect and interest rate adjusts quickly
to changes in expected inflation
C) Liquidity effect is larger than the expected inflation effect and interest rate adjusts slowly
to changes in expected inflation
D) Liquidity effect is smaller than the expected inflation effect and interest rate adjusts
slowly to changes in expected inflation

Part 3. Practice exercises

Questions taken from chapter 5 (Mishkin, 2019)
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.
=> Less, because your wealth has declined
b. You expect the stock to appreciate in value.
=> more, because its relative expected return has risen
c. The bond market becomes more liquid.
=> less, because it has become less liquid relative to bonds
d. You expect gold to appreciate in value.
=> less, because its expected return has fallen relative to gold
e. Prices in the bond market become more volatile.
=> more, because it has become less risky relative to bond

4. Explain why you would be more or less willing to buy long-term Delta Air Lines bonds
under the following circumstances:
a. The company just released its financial statements, indicating that income decreased and
liabilities increased.
=> Less, because it has become more risky

b. You expect a bull market in stocks (stock prices are expected to increase).
=> less, because their expected return has fallen relative to stocks.

c. You have analyzed your country’s monetary policy and expect interest rates to decrease.
=> more, because its relative expected return has risen

d. Brokerage commissions on bonds fall.

=> more, because its relative expected return has risen

e. Your income and wealth increased over the last two years.
=> More

6. Raphael observes that at the current level of interest rates there is an excess supply of
bonds, and therefore he anticipates an increase in the price of bonds. Is Raphael correct?

=> Raphael is incorrect. If at the current level of interest rates there is an excess supply of
bonds, the bond's price will fall and the interest rate will rise to the equilibrium level.

12. Will there be an effect on interest rates if brokerage commissions on stocks fall? Explain
your answer.

=> Yes, interest rates will rise. The lower commission on stocks makes them more liquid
relative to bonds, and the demand for bonds will fall. The demand curve for bonds will
therefore shift to the left, and the equilibrium interest rate will rise.
13. 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.

If the public believes the president's program will be successful, interest rates will fall. The
president's announcement will lower expected inflation so that the expected return on goods
decreases relative to bonds. The demand for bonds increases and the demand curve, B', shifts
to the right. For a given nominal interest rate, the lower expected inflation means that the real
interest rate has risen, raising the cost of borrowing so that the supply of bonds falls. The
resulting leftward shift of the supply curve, B', and the rightward shift of the demand curve,
B', causes the equilibrium interest rate to fall.

18. If the next chair of the Federal Reserve Board has a reputation for advocating an even
slower rate of money growth than the current chair, what will happen to interest rates?
Discuss the possible resulting situations.

The slower rate of money growth will lead to a liquidity effect, which raises interest rates,
while the lower price level, income, and inflation rates in the future will tend to lower interest
rates.
There are three possible scenarios for what will happen:
(a) if the liquidity effect is larger than the other effects, then interest rates will rise;

(b) if the liquidity effect is smaller than the other effects and expected inflation adjusts
slowly,
then interest rates will rise at first but will eventually fall below their initial level;
,(c) if the liquidity effect is smaller than the expected inflation effect and there is rapid
adjustment of expected inflation, then interest rates will immediately fall.