2.) Using the liquidity preference model, explain why an unexpected increase in the money supply is more likely to decrease short-term interest rates than a fully anticipated increase in the money supply.
3.) The following question asks you to examine the effects of expected inflation in the liquidity premium model of yield curves.
a.) Using the bond market equilibrium model, show the effects of an increase in expected inflation on the price of bonds. What will happen to nominal interest rates?
b.) Suppose that expected inflation is 2% per year for the next 30 years. Notice that total inflation over the 30 year period is expected to 60% (the sum of expected inflation each year). Draw an upward sloping yield curve for discount bonds (bonds that make no coupon payments) with terms to maturity ranging from 0 to 30 years.
c.) Suppose that expected inflation increases from 2% per year to 3% every year for the next 30 years. Show the effect this would have on the yield curve you drew in b.). Note that total inflation over the 30-year period is now expected to by 90%.
d.) Suppose that instead of the gradual increase in expected inflation in part c.), expected inflation only increases in year 0 (immediately), but increases from 2% to 32%. Show the effects this would have on the yield curve you drew in b.). Note that total inflation over the 30-year period is still expected to by 90%, as in c.).
e.) How would the yield on a 30-year discount bond in part c.) compare to the yield on a 30-year discount bond in part d.)?
4.) Using the Gordon model of stock prices, what impact do you think each of the following would have on the price of stocks? Explain your answers.
a.) An increase in expected inflation
b.) A decrease in taxes on middle class households
c.) An increase in the fraction of the population over the age of 60
Sample Solution