1 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. 2 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.

1. 1
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

2. 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

3. 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.
2
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

4. 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

5. 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

6. 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

7. 3
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

8. 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

9. 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.
4
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

10. 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

11. 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

12. stay at 5%,
and that their investment analysts should either see
psychoanalysts or go
to prison or both.