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Tutorial Questions
ECON7200
1. Suppose you visit with a financial adviser, and you are considering investing some of
your wealth in one of three investment portfolios: stocks, bonds, or commodities. Your
financial adviser provides you with the following table, which gives the probabilities
of possible returns from each investment:
Stocks Bonds Commodities
Probability Return Probability Return Probability Return
0.2 15% 0.5 12% 0.2 20%
0.3 8.3% 0.5 6% 0.25 12%
0.2 10% 0.25 6%
0.3 5% 0.2 5%
0.1 0.10%
a. Which investment should you choose to maximize your expected return:
stocks, bonds, or commodities?
b. If you are risk-averse and have to choose between the stock and the bond
investments, which should you choose? Why?
2. An important way in which the Federal Reserve decreases the money supply is by
selling bonds to the public. Using a supply and demand analysis for bonds, show what
effect this action has on interest rates. Is your answer consistent with what you would
expect to find with the liquidity preference framework?
3. Using both the liquidity preference framework and the supply and demand for bonds
framework, show why interest rates are procyclical (rising when the economy is
expanding and falling during recessions).
4. The demand curve and supply curve for one-year discount bonds with a face value of
$1,000 are represented by the following equations:
a. Bd: Price = −0.8 * Quantity + 1100
b. Bs: Price = Quantity + 680
a) What is the expected equilibrium price and quantity of bonds in this market?
b) Given your answer to part (a), what is the expected interest rate in this market?
5. What will happen to the bond market, in particular to the equilibrium price and
interest rates, if the government imposes a limit on the amount of daily transactions?
6. M1 money growth in the US was about 15% in 2011 and 2012, and 10% in 2013.
Over the same time period, the yield on 3-month Treasury bills was close to 0%.
Given these high rates of money growth, why did interest rates stay so low, rather
than increase? What does this say about the income, price-level and expected-
inflation effects?
MCQs
1. In the 1990s Japan had the lowest interest rates in the world due to a combination of
A) inflation and recession.
B) deflation and expansion.
C) inflation and expansion.
D) deflation and recession.
2. If the expected return on bonds increases, all else equal, the demand for bonds increases,
the price of bonds ________, and the interest rate ________.
A) increases; decreases
B) increases; increases
C) decreases; decreases
D) decreases; increases
3. 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 rates adjust
quickly to 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.
4. 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.
5. In the market for money, an interest rate below equilibrium results in an excess ________
money and the interest rate will ________.
A) demand for; rise
B) demand for; fall
C) supply of; fall
D) supply of; rise
6. Everything else held constant, if the expected return on RST stock declines from 12 to 9
percent and the expected return on XYZ stock declines from 8 to 7 percent, then the expected
return of holding RST stock ________ relative to XYZ stock and demand for XYZ stock
________.
A) rises; rises
B) rises; falls
C) falls; rises
D) falls; falls
7. The reduction of brokerage commissions for trading common stocks that occurred in 1975
caused the demand for bonds to ________ and the demand curve to shift to the ________.
A) fall; right
B) fall; left
C) rise; right
D) rise; left
8. Deflation causes the demand for bonds to ________, the supply of bonds to ________, and
bond prices to ________, everything else held constant.
A) increase; increase; increase
B) increase; decrease; increase
C) decrease; increase; increase
D) decrease; decrease; increase
9. Everything else held constant, when prices in the art market become more uncertain
A) the demand curve for bonds shifts to the left and the interest rate rises.
B) the demand curve for bonds shifts to the left and the interest rate falls.
C) the demand curve for bonds shifts to the right and the interest rate falls.
D) the supply curve for bonds shifts to the right and the interest rate falls.
10. 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.
