Exercises for Chapter 9

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? 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.

(a) If current two-year market interest rates are 4 percent, what is the market price of your bond?

(b) If market interest rates rise tomorrow to 6 percent, what will be the market price of your bond?

(c) What is the “market risk” in holding bonds?

Exercise 9.3 You are holding a cash balance that you want to place in the bond market for a period of three years. The market rate of interest on three year bonds today is 5.5 percent. Would you be willing to pay $1,015 for a$1,000 bond with a 6 percent coupon maturing three years from today? Explain your answer.

Exercise 9.4 Draw a diagram to illustrate the relationship between the demand for real money balances and the interest rate, $$L = kY − hi$$ when real GDP has a given value Y0.

(a) 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.

(b) 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.

(c) 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.

(d) 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 9.5 Draw a diagram to illustrate equilibrium in the money market.

Exercise 9.5 Draw a diagram to illustrate equilibrium in the money market.

(a) Starting from your initial equilibrium, suppose real national income increased. Illustrate and explain how the money market would adjust to this change in economic conditions.

(b) How does the interest rate in the new equilibrium compare with the interest rate in the initial equilibrium?

Exercise 9.6 Draw a diagram to illustrate the foreign exchange market in which Euros are bought with or sold for Canadian dollars, assuming the current exchange rate is \$1.54Cdn=1 Euro. Starting from that equilibrium exchange rate, suppose Canadian interest rates fall relative to European rates. Using your foreign exchange market, show how the dollar-euro exchange rates would be affected.

Exercise 9.7 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:

(a) How a reduction in the money supply would affect aggregate demand and output.

(b) 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.

(c) Alternatively, how an increase in autonomous investment expenditure and exports would affect interest rates, aggregate demand, and output.