Economics 211 Due March 5, 2020 Spring Semester Professor

economics 211 Due Thursday March 5 2020spring Semester Profe

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.

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. )

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 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. If not, explain why.

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.

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.

Paper For Above instruction

Understanding the dynamics of bond markets and the implications of various economic events requires an in-depth analysis of supply and demand frameworks, expectations theories, and macroeconomic policies. This paper explores several scenarios related to bond pricing, interest rate movements, monetary policy impacts, and equity valuation models, synthesizing theoretical concepts with practical illustrations to provide a comprehensive understanding of the subject matter.

Bond Markets and Demand-Supply Frameworks

Bond prices and interest rates are inversely related; this fundamental principle is frequently depicted through the two-axis supply and demand diagram, with bond prices on the y-axis and the interest rate (or yield) on the right, inverted axis. In the case of a fall in expected inflation, the inflation premium embedded in bond yields diminishes, leading to an increase in bond prices and a fall in interest rates. The demand curve shifts rightward as investors anticipate lower inflation, enhancing bond attractiveness. Conversely, a non-U.S. economic expansion typically enhances foreign investment inflows, increasing demand for bonds, raising prices, and lowering yields, though shifts depend on global risk perceptions (Mishkin, 2019).

Impacts of Market Expectations and Liquidity

The supply and demand model for money shows that an increased risk of currency fraud decreases the acceptability of local currency, thereby reducing money demand. If the Federal Reserve maintains the money supply, bond prices and interest rates are initially unaffected, but the decreased money demand could result in higher interest rates over the longer term (Mishkin, 2019). When expectations shift assertively towards stocks, money demand declines as investors favor equities, potentially causing interest rates to fall if the Fed does not adjust money supply correspondingly. These scenarios highlight the importance of central bank policy in stabilizing financial markets during expectation-driven shifts.

Monetary Policy and Interest Rate Trajectories

Central banks aiming to reduce interest rates through expansionary monetary policy often observe interest rates declining gradually over time, influenced by modifications in inflation expectations and economic sentiment. In a well-regarded inflation stabilization environment, the interest rate path exhibits a steeper decline initially, stabilizing as expectations adjust. Conversely, in a poorly perceived inflation context, increased inflation expectations may cause interest rates to initially spike despite monetary expansion, illustrating a divergent trajectory (Mishkin, 2019). These patterns reinforce the importance of credible monetary policies in managing interest rate expectations.

Expectations Theory and the Term Structure

The expectations theory posits that long-term interest rates reflect anticipated future short-term rates. With a current 1-year rate of 50% and expectations of a 70% rate in one year, the current 2-year rate can be derived as:

Let r₂ be the current 2-year rate.

Applying the formula: (1 + r₂)² = (1 + r₁) x (1 + expected rate in one year) = (1 + 0.50) x (1 + 0.70) = 1.50 x 1.70 = 2.55

Therefore, r₂ = sqrt(2.55) - 1 ≈ 0.595, or 59.5%. Under the liquidity premium theory, an added premium implies the yield curve slopes upward further, and increased risk aversion among investors would accentuate this upward shift, reflecting higher premiums for longer maturities (Mishkin, 2019).

Bond Yields and Credit Risk

Bond yields for corporate debt like BigCon are sensitive to perceived credit risk. Improved financial outlook reduces the risk premium, decreasing corporate bond yields, narrowing the spread with Treasury bonds. Conversely, simultaneous plans for expansion raise the supply of bonds, potentially increasing yields unless demand increases proportionally. The interplay of credit ratings, market expectations, and issuance volume critically influence yield movements (Fama & French, 2004).

Dividend Valuation and Stock Price Calculation

The Gordon Growth Model states that the stock price (P) equals dividends per share divided by the difference between the required return (ke) and growth rate (g): P = D₁ / (ke - g). Given D₁= $80, ke = i_er + s = 3% + 5% = 8%, and g=0%, the stock's price is:

P = $80 / (0.08 - 0) = $1000

If the dividend growth rate increases to 4%, then:

P = $80 / (0.08 - 0.04) = $2000

Adjustments to perceived risk or profit estimation, such as overestimated assets, affect the required return (ke) or the expected growth rate (g), thereby influencing stock valuations (Gordon, 1959).

Impacts of Macroeconomic Expectations on Stock Prices

If investors revise their premiums or growth expectations based on information about asset overestimation or changes in risk appetite, the stock prices adjust accordingly. For example, an increased risk premium raises ke, lowering stock prices; a lower expected growth rate similarly decreases valuations (Fama & French, 2004). These dynamics illustrate the sensitivity of equity prices to perception shifts and fundamental information, emphasizing the importance of accurate financial disclosures and macroeconomic stability for investor confidence.

References

• Fama, E. F., & French, K. R. (2004). The Capital Asset Pricing Model: Theory and Evidence. Journal of Economic Perspectives, 18(3), 25–46.
• Gordon, M. J. (1959). Dividends, Earnings, and Stock Prices. Review of Economics and Statistics, 41(2), 99–105.
• Mishkin, F. S. (2019). The Economics of Money, Banking, and Financial Markets (12th ed.). Pearson.
• Fama, E. F., & French, K. R. (2004). The Capital Asset Pricing Model: Theory and Evidence. Journal of Economic Perspectives, 18(3), 25-46.
• Gordon, M. J. (1959). Dividends, Earnings, and Stock Prices. Review of Economics and Statistics, 41(2), 99–105.
• Fama, E. F., & French, K. R. (2004). The Capital Asset Pricing Model: Theory and Evidence. Journal of Economic Perspectives, 18(3), 25–46.
• Mishkin, F. S. (2019). The Economics of Money, Banking, and Financial Markets (12th ed.). Pearson.
• Fama, E. F., & French, K. R. (2004). The Capital Asset Pricing Model: Theory and Evidence. Journal of Economic Perspectives, 18(3), 25–46.
• Gordon, M. J. (1959). Dividends, Earnings, and Stock Prices. Review of Economics and Statistics, 41(2), 99–105.
• Mishkin, F. S. (2019). The Economics of Money, Banking, and Financial Markets (12th ed.). Pearson.