2 Econ exams will send exam by screenshot

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Economics 211 Due Thursday, March 5, 2020

Spring Semester Professor John Duca

Homework #2 (NOTE: Assignments to be handwritten except for approved disabilities or

approved circumstances. Assignments are to be turned in by the BEGINNING of class

on the due date or into my mailbox in the Economics Department (223 Rice Hall) by the

beginning of class on the due date. WHERE YOU CAN, SHOW THE FORMULAS

THAT YOU ARE USING AND ANY RELEVANT CALCULATIONS.

1) Using the more complicated 2-axis, supply and demand framework for bonds presented in class (bond prices on the left y-axis, and INVERTED interest rates on

the right y-axis), illustrate an initial equilibrium and then show which curve will

likely shift (or curves shift) (if any) in response to the following changes in market

conditions. In each case, state what happens to the bond price and what happens to

the interest rate (up, down, or unchanged) (20 points). Use separate diagrams for (a)

and for (b).

a) There is a fall in expected inflation. b) There is a business cycle expansion in a non-U.S. economy.

2) Using the supply and demand framework for money presented in chapter 5 of the Mishkin text, illustrate what happens to the equilibrium quantity of money held and

interest rates if the following events occurred. In each case, assume that there are no

income, price level, or expected inflation effects—that is only consider the initial

liquidity effects: (10 points)

a) The risk of currency fraud rises so that currency has become less accepted as a means of payment by many firms or entail much longer delays to

verify that the currency is not counterfeit. Illustrate what happens to the

demand for money. Illustrate what happens if, in response, the Federal

Reserve alters the supply of money so that bond prices (and thus interest

rates) are unchanged.

b) There is a large change in expectations such that people see stocks as a much more attractive investment. As a result, people shift toward stocks

and away from money market mutual funds and savings deposits.

Illustrate what happens if, in response, the Federal Reserve alters the

supply of broadly defined money (that is, M2) so that bond prices (and

thus interest rates) are unchanged.

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3) Suppose a central bank wants to stimulate the economy by lowering interest rates through expanding the money supply under the following conditions. Illustrate how

interest rates change over time using the appropriate framework from the appropriate

section of Mishkin’s textbook (this was covered in class). Clearly indicate when the

monetary action occurs, and label which type or types of effects on interest rates are

occurring at different times. (15 points)USE SEPARATE DIAGRAMS for 3a & 3b

a) Suppose that you are in a country that has a great reputation for stabilizing long- run inflation. Suppose that in response to slowing aggregate demand, the central

bank tries to stimulate the economy by increasing the money supply. What

happens to the path of interest rates over time—draw the appropriate chart? Label

the different effects on interest rates under the x-axis. What happens to the path of

interest rates over time? (7 points)

b) Suppose that you are in a country that has a bad reputation for over-stimulating the economy in downturns and letting inflation surge. In addition, investors see

the current central bank as willing to let inflation rise to get the economy growing

quickly again. This central bank tries to stimulate the economy by increasing the

money supply. In a separate diagram from part (a), copy the time line you drew

for part (a) (label the line (a)) and then add in the time path from this case (b)

(label this line (b)). Label the different effects on interest rates for case (b) under

the x-axis. (8 points)

4) Suppose the current 1-year (short term) interest rate is 50 percent and that markets expect the 1-year (short-term) interest rate will be 70 percent one year from now.

(15 points)

a) Draw a yield curve covering terms to maturity ranging from 1 to 2 years according to the expectations theory of the term structure. Calculate

(show your formulas and work) the current 2-year interest rate. Clearly

indicate on a drawn yield curve what the current 1-year and current 2-year

bond yields are.

b) Now assume that the liquidity premium theory holds. Draw a plausible yield curve along with the yield curve in case (a). Assuming that the

liquidity premium theory is correct, what would likely happen if investors

became more risk averse? Illustrate this.

5) Using the supply and demand framework for bonds, illustrate what happens to corporate and Treasury bond yields in response to the following developments in

a world where there is only one corporation (BigCon) that has and can issue

bonds. Be sure to illustrate the corporate and Treasury markets side by side,

clearly labeling any initial and final yield differences, along with the initial and

final levels of corporate and Treasury yields. Assume that there is no prepayment

risk on any of the bonds and that there are no differences in liquidity, maturity, or

tax treatment between these 2 types of bonds. Finally assume that BigCon can

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only incur debt by issuing bonds. (10 points)

a) Suppose that the ratings companies (e.g., Moodys and Standard & Poors) and investors see the BigCon corporation as posing a medium initial level

of default risk. Now suppose that BigCon just made a surprise

announcement that its financial condition and outlook have greatly

improved but that it will not change any plans to expand its operations

with external financing. Does anything likely change? If so, illustrate

what happens in each market and what happens to relative interest rates.

b) Now in addition to the effect on bond demand in (a) suppose instead that BigCon does adjust its plans to expand its facilities using debt financing in

light of its new outlook. In a separate chart, plot both the demand shifts

from (a) with the additional supply shift in (b). Does anything likely

differ from case a? If so, illustrate what happens in each market and what

happens to relative interest rates.

6) Assume that the Dividend Valuation or Gordon Growth Model is correct and that investors plan on holding stock for such a long time that the final sales price does

not affect valuations. Also assume that the required return on an investment in

equity (ke) equals the expected real long-term Treasury bond yield (i e r ) plus some

“equity” premium (s) (the equity premium is the extra expected return on equities

versus bonds that compensates stockholders for the extra risk of investing in

stocks over bonds). In other words, ke = i e r + s. (10 points)

a) Suppose that the EndRun Corporation pays dividends of $80 per year that are not expected to ever change (in both (a) and (b)), the expected real

long-term Treasury bond yield equals 3 percent, and the equity premium is

5 percent. What is the equilibrium price of a share in this company?

Show your calculations. 7 points.

b) Compared to case (a), what is likely to happen if investors learn that the accounting firm (C.F. Eyecare) used by all companies that have issued

stock had greatly overestimated the assets owned by these companies but

correctly accounted for their recent and projected profits? If something

changes, indicate which component of the Gordon Growth model will

likely change and in what direction. 3 points.

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7) Assume that the Gordon Growth Model is correct and that investors plan on holding stock for such a long time that the final sales price does not affect

valuations. Also assume that the required return on an investment in equity (ke)

equals the expected real long-term Treasury bond yield (ier ) plus some “equity”

premium (s) (the equity premium is the extra expected return on equities versus

bonds that compensates stockholders for the extra risk of investing in stocks over

bonds). In other words, ke = i e r + s. (20 points)

a) Suppose that the GoGoGrowth Corporation pays dividends of $20 per year in the first period (D1 = $20), that the expected annual growth rate of

dividends is a constant 2 percent, the expected real long-term Treasury

bond yield equals 5 percent, and the equity premium is 7 percent. What is

the equilibrium price of a share in this company? Show your calculations.

b) Keeping all else the same, what happens to the equilibrium price if the expected annual (constant) growth rate of the dividend increases to 4

percent? Show your calculations.

c) Continue to assume that investors expect dividends to grow at a 4 percent constant annual growth rate. What happens to the equilibrium price of the

stock if investment analysts and stockbrokers convince investors that the

equity premium should be 4 percent instead of 7 percent? Show your

calculations.

d) Compared to case (c), what happens to the equilibrium price of stocks if both of the following occur:

1) investors discover that accountants, investment analysts, and CEOs

misled them into mistakenly believing that dividends would grow 4

percent when dividends were in fact growing only 3 percent per year,

And 2) investors discover that the equity premium should really be 8

percent (not 3 percent), while real long-term Treasury yields stay at 5%,

and that their investment analysts should either see psychoanalysts or go

to prison or both.