9.8: Exercises for Chapter 9

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EXERCISE 9.1

If the current market interest rate is 3 percent and a bond promises a coupon of $3 each year in perpetuity (forever), what is the current market price of the bond? Suppose you were holding such a bond and current market interest rates fell from 3 percent to 2.5 percent. Would you be pleased or disappointed by the return on your bond holding? Why?

EXERCISE 9.2

Suppose you are holding a bond that will pay $5 each year for the next two years from today and mature two years from today.

If current two-year market interest rates are 5 percent, what is the market price of your bond?
If market interest rates rise tomorrow to 6 percent, what happens to the market price of your bond?
What is the "market risk" in holding bonds?

EXERCISE 9.3

Draw a diagram to illustrate the relationship between the demand for real money balances (L), GDP (Y) and the interest rate (i), L=kY–hi, when real GDP has a given value Y₀.

Explain your choice of the intersection of your demand for money function with the horizontal axis, and your choice of the slope of the function.
Using your diagram, illustrate and explain the quantity of real money balances demanded for a specific interest rate, say i₀. Pay particular attention to the underlying motives for holding these money balances.
Suppose interest rates declined from your initial assumption of i₀ to a new lower rate i₁. Illustrate and explain the effect of the change in interest rates on the demand for money balances.
Holding interest rates constant at either i₀ or i₁, suppose real GDP were to increase. Illustrate and explain the effect of the increase in real GDP on the demand function and the quantity of real money balances people hold.

EXERCISE 9.4

Today it costs $1.25Cdn to buy $1US. Suppose tomorrow US interest rates rise. What would happen to the foreign exchange rate between Canadian and US dollars? Explain why.

EXERCISE 9.5

Draw a diagram to illustrate equilibrium in the money market.
Starting from your initial equilibrium, suppose real national income (Y) increased. Illustrate and explain how the money market would adjust to this change in economic conditions.
How does the interest rate in the new equilibrium compare with the interest rate in the initial equilibrium?

EXERCISE 9.6

Construct a set of diagrams that shows the monetary transmission mechanism linking interest rates to aggregate demand and output. Using these diagrams, show and explain:

How a reduction in the money supply would affect aggregate demand and output.
Alternatively, how an increase in the precautionary demand for money balances caused by terrorist activity, or severe weather events, or an increase in uncertainty in general would affect aggregate demand and output. Assume the money supply is held constant.
Alternatively, how would an increase in autonomous investment expenditure and exports affect aggregate demand, output, and interest rates?