Economics of Money, Banking and Financial Markets, The, Business School Edition, 5th Edition Solution Manual

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PARTTHREEAnswersto End-of-ChapterQuestions and Problems

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Mishkin•Instructor’s Manual forTheEconomics of Money, Banking, and Financial Markets, Business School Edition, Fifth Edition57Chapter 1ANSWERS TO QUESTIONS1.What is the typical relationship among interest rates on three-month Treasury bills, long-term Treasury bonds, and Baa corporate bonds?The interest rate on three-month Treasury bills fluctuates more than the other interest rates andis loweron average. The interest rate on Baa corporate bonds is higher on average than theother interest rates.2.What effect might a fall in stock prices have on business investment?The lower price for a firm’s shares means that it can raise a smaller amount of funds, soinvestment in facilities and equipment will fall.3.Explain the main difference between a bond and a common stock.A bond is a debt instrument, which entitles the owner to receive periodic amounts of money(predetermined by the characteristics of the bond) until its maturity date. A common stock,however, represents a share of ownership in the institution that has issued the stock. Inaddition to its definition, it is not the same to hold bonds or stock of a given corporation,since regulations state that stockholders are residual claimants (i.e. the corporation has to payall bondholders before paying stockholders).4.Explain the link between well-performing financial markets and economic growth. Name onechannel through which financial markets might affect economic growth and poverty.Well performing financial markets tend to allocate funds to its more efficient use, therebyallowing the best investment opportunities to be undertaken. The improvement in theallocation of funds results in a more efficient economy, which stimulates economic growth(and thereby poverty reduction).5.What was the main cause of the recession that began in 2007?The United States’economy was hit by the worst financial crisis since the Great Depression.Defaults in subprime residential mortgages led to major losses in financial institutions,producing not onlynumerous bank failures but also the demise of two of the largestinvestment banks in the United States. These factors led to the “Great Recession”thatbeganlate in 2007.

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Mishkin•Instructor’s Manual forTheEconomics of Money, Banking, and Financial Markets, Business School Edition, Fifth Edition586.Can you think of a reason why people in general do not lend money to one another to buy ahouse or a car? How would your answer explain the existence of banks?In general,people do not lend large amounts of money to one another because of severalinformation problems. In particular, people do not know about the capacity of other people ofrepaying their debts, or the effort they will provide to repay their debts. Financialintermediaries, in particular commercial banks, tend to solve these problems by acquiringinformation about potential borrowers and writing and enforcing contracts that encouragelenders to repay their debt and/or maintain the value of the collateral.7.What are the other important financial intermediaries in the economy, besides banks?Savings and loan associations, mutual savings banks, credit unions, insurance companies,mutual funds, pension funds, and finance companies.8.Can you date the latest financial crisis in the United States or in Europe? Are there reasonsto think that these crises might have been related? Why?The latest financial crisis in the United Statesand Europe occurred in 2007–2009. At thebeginning it hit mostly the US financial system, but it then quickly moved to Europe, sincefinancial markets are highly interconnected. One specific way in which these markets wererelated is that some financial intermediaries in Europe held securities backed by mortgagesoriginated in theUnited States, and when these securities lost their a considerable part oftheir value, the balance sheet of European financial intermediaries wasadversely affected.9.Has the inflation rate in the United States increased or decreased in the past few years?What about interest rates?From 2014 to mid-2017, inflation has been somewhat low, but increased more recently tonear 2%; interest rates have moved in a fairly narrow range, with the benchmark 10-yearUS treasury rate moving from a high of around 2.5%, to as low as about 1.5% then increasingagain.10.If history repeats itself and we see a decline in the rate of money growth, what might youexpect to happen toa.real output?b.the inflation rate?c.interest rates?The data in Figures 3, 5, and 6 suggest that real output, the inflation rate, and interest rateswould all fall.

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Mishkin•Instructor’s Manual forTheEconomics of Money, Banking, and Financial Markets, Business School Edition, Fifth Edition5911.When interest rates decrease, how might businesses and consumers change their economicbehavior?Businesses would increase investment spending because the cost of financing this spending isnow lower, and consumers would be more likely to purchase a house or a car because thecost of financing their purchase is lower.12.Is everybody worse off when interest rates rise?No. It is true that people who borrow to purchase a house or a car are worse off because itcosts them more to finance their purchase; however, savers benefit because they can earnhigher interest rates on their savings.13.Why do managers of financial institutions care so much about the activities of the FederalReserve System?Because the Federal Reserve affects interest rates, inflation, and business cycles, all of whichhave an important impact on the profitability of financial institutions.14.How does the current size of the U.S. budget deficit compare to the historical budget deficitor surplus for the time period since 1950?The deficit as a percentage of GDP expanded dramatically in 2007 but improved starting in2010; in 2009,the deficit to GDP ratio was 9.8%, and in 2016 was 3.2%, still above thehistorical average of around 2% since 1950.15.How would a fall in the value of the pound sterling affect British consumers?It makes foreign goods more expensive, so British consumers will buy fewer foreign goodsand more domestic goods.16.How would an increase in the value of the pound sterling affect American businesses?It makes British goods more expensive relative to American goods. Thus,Americanbusinesses will find it easier to sell their goods in the United States and abroad, and thedemand for their products will rise.17.How can changes in foreign exchange rates affect the profitability of financial institutions?Changes in foreign exchange rates change the value of assets held by financial institutionsand thuslead to gains and losses on these assets. Also changes in foreign exchange rates affectthe profits madeby traders in foreign exchange who work for financial institutions.

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Mishkin•Instructor’s Manual forTheEconomics of Money, Banking, and Financial Markets, Business School Edition, Fifth Edition6018.According to Figure 8, in which years would you have chosen to visit the Grand Canyon inArizona rather than the Tower of London?In the mid-to late 1970s,the late 1980s to early 1990s,and 2008 to 2015, the value of thedollar was low, making travel abroad relatively more expensive; thus,it was a good time tovacation in the United States and see the Grand Canyon. With the rise in the dollar’s value inthe early 1980s, late 1990s, and after 2015, travel abroad became relatively cheaper, making ita good time to visit the Tower of London. This was also true, to a lesser extent, in the early2000s.The following table lists the foreign exchange rate between U.S. dollars and British pounds(GBP) during May 2017. Which day would have been the best for converting $200 into Britishpounds? Which day would have been the worst? What would be the difference in pounds?Date$/£5-011.29175-021.29215-031.29165-041.29105-051.295005-081.294205-091.293905-101.293905-111.288505-121.288005-151.291705-161.291205-171.294405-181.300905-191.301805-221.300605-231.298405-241.293505-251.295405-261.279505-301.285805-311.2905

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Mishkin•Instructor’s Manual forTheEconomics of Money, Banking, and Financial Markets, Business School Edition, Fifth Edition6119.When the dollar is worth more in relation to currencies of other countries, are you morelikely to buy American-made or foreign-made jeans? Are U.S. companies thatmanufacturejeans happier when the dollar is strong or when it is weak? What about an Americancompany that is in the business of importing jeans into the United States?When the dollar increases in value, foreign goods become less expensive relative toAmerican goods; thus,you are more likely to buy French-made jeans than American-madejeans. The resulting drop in demand for American-made jeans because of the strong dollarhurts American jeans manufacturers. On the other hand, the American company that importsjeans into the United States now finds that the demand for its product has risen, so it is betteroff when the dollar is strong.20.Much of the U.S. government debt is held by foreign investors as treasury bonds and bills.How do fluctuations in the dollar exchange rate affect the value of that debt held byforeigners?As the dollar becomes stronger (worth more) relative to a foreign currency, one dollar isequivalent to(can be exchanged for) more foreign currency. Thus, for a given face value ofbond holdings, a strongerdollar will yield more home currency to foreigners, so the asset willbe worth more to foreign investors. Likewise, a weak dollar will lead to foreign bond holdingsworth less to foreigners.ANSWERS TO APPLIED PROBLEMS21.The following table lists the foreign exchange rate between U.S. dollars and British pounds(GBP) during May 2017. Which day would have been the best for converting $200 intoBritish pounds? Which day would have been the worst? What would be the difference inpounds?5-011.29175-021.29215-031.29165-041.29105-051.295005-081.294205-091.293905-101.293905-111.288505-121.288005-151.291705-161.291205-171.294405-181.300905-191.3018

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Mishkin•Instructor’s Manual forTheEconomics of Money, Banking, and Financial Markets, Business School Edition, Fifth Edition6205-221.300605-231.298405-241.293505-251.295405-261.279505-301.285805-311.2905The best day is 5/26. At a rate of $1.2795/pound, you would have £156.31. The worst day is5/19. At $1.3018/pound, you would have £153.63, or a difference of £2.68ANSWERS TO DATA ANALYSIS PROBLEMS1.Go to the St. Louis Federal Reserve FRED database and find data on the three-monthtreasury bill rate (TB3MS), the three-month AA nonfinancial commercial paper rate(CPN3M), the 30-year treasury bond rate (GS30), the 30-year fixed rate mortgage average(MORTGAGE30US), and the NBER recession indicators (USREC). For the mortgage rateindicator, set the frequency setting to ‘monthly’.a.In general, how do these interest rates behave during expansionary periods?Generally speaking, the interest rates fall during recessions, and rise during expansionaryperiods.b.In general, how do the three-month interest rates compare to the 30-year rates? How dothe Treasury rates compare to the respective commercial paper and mortgage rates?In nearly all instances, the 30-year rates are significantly higher than the three-monthrates. Likewise, in most cases, the 30-year mortgage rate is higher than the 30-yeartreasury rate, and the three-month commercial paper rate is higher than the three-monthtreasury rate.c.For the most recent available month of data, take the average of each of the three-monthrates and compare it to the average of the three-month rates from January 2000. How dothe averages compare?d.For the most recent available month of data, take the average of each of the 30-yearrates and compare it to the average of the 30-year rates from January 2000. How do theaverages compare?May 2017January 2000Three-month rate avg.0.925.5330-year rate avg.3.497.42See table above. For both rate averages, they have decreased significantly since January

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Mishkin•Instructor’s Manual forTheEconomics of Money, Banking, and Financial Markets, Business School Edition, Fifth Edition632000.2.Go to the St. Louis Federal Reserve FRED database and find data on the M1 money supply(M1SL) and the 10-year treasury bond rate (GS10). Add the two series into a single graph byusing the “Add Data Series” feature. Transform the M1 money supply variable into the M1growth rate by adjusting theunitsfor the M1 money supply to “Percent Change from YearAgo.”a.In general, how have the growth rate of the M1 money supply and the 10-year treasurybond rate behaved during recessions and during expansionary periods since the year2000?Generally, the 10-year treasury rate fell during the recessionary periods of 2001 and2007–2009; during expansionary periods, there was less of a pattern, but there seems tobe a long-run downward trend in the interest rate. The money growth rate increasedsignificantly during recessionary periods;however,during expansions,there is less of apattern; following the 2001 recession, money growth gradually declined, but after the2007–2009 recession, money growth was relatively high and variable.b.In general, is there an obvious, stable relationship between money growth and the 10-year interest rate since the year 2000?When money growth rises, the 10-year treasury rate appears to fall, and vice-versa;however,this effect is more obvious over some periods than others.c.Compare the money growth rate and the 10-year interest rate for the most recent monthavailable to the rates for January 2000. How do the rates compare?May 2017January 2000M1 Money Growth8.002.1910-yeartreasury rate2.306.66The money growth rate is significantly higher in May 2017 than it was in January 2000.The 10-year treasury rate is significantly lower in May 2017 than it was in January 2000.

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Mishkin•Instructor’s Manual forTheEconomics of Money, Banking, and Financial Markets, Business School Edition, Fifth Edition64Chapter 2ANSWERS TO QUESTIONS1.If I can buy a car today for $5,000 and it is worth $10,000 in extra income to me next yearbecause it enables me to get a job as a traveling salesman, should I take out a loan fromLarry the Loan Shark at a 90% interest rate if no one else will give me a loan? Will I bebetter or worse off as a result of taking out this loan? Can you make a case for legalizingloan sharking?Yes, I should take out the loan, because I will be better off as a result of doing so. My interestpaymentwill be $4,500 (90% of $5,000), but as a result, I will earn an additional $10,000, soI will be ahead of the game by $5,500. Since Larry’s loan-sharking business can make somepeople better off, as in this example, loan sharking may have social benefits. (One argumentagainst legalizing loan sharking, however, is that it is frequently a violent activity.)2.Some economists suspect that one of the reasons economies in developing countries grow soslowly is that they do not have well-developed financial markets. Does this argument makesense?Yes, because the absence of financial markets means that funds cannot be channeled topeople who have the most productive use for them. Entrepreneurs then cannot acquire fundsto set up businesses that would help the economy grow rapidly.3.Give at least three examples of a situation in which financial markets allow consumers tobetter time their purchases.Examples of how financial markets allow consumers to better time their purchases include•The purchase of a durable good, like a car or furniture.•Paying for tuition.•Paying the cost of repairing a flooded basement.In all three cases, consumers were able to pay for a good or service (education or thereparation of a flooded basement) without having to wait to save enough and only then beingable to afford such goods and services.4.If you suspect that a company will go bankrupt next year, which would you rather hold,bonds issued by the company or equities issued by the company? Why?You would rather hold bonds, because bondholders are paid off before equity holders, whoare the residual claimants.5.Suppose that Toyota sells yen-denominated bonds in Tokyo. Is this debt instrumentconsidered a Eurobond? How would your answer change if the bond were sold in New York?If the Yen denominated bond is sold in Tokyo, then it is not considered a Eurobond. If thebond is sold in New York, then it is considered a Eurobond.

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Mishkin•Instructor’s Manual forTheEconomics of Money, Banking, and Financial Markets, Business School Edition, Fifth Edition656.Describe who issues each of the following money market instruments:a.Treasury billsb.Certificates of depositc.Commercial paperd.Repurchase agreemente.Fed fundsTreasury bills are short-term debt instruments issued by the US government to coverimmediate spending obligations, i.e. finance deficit spending. Certificates of deposit (CD) areissued by banks and sold to depositors. Corporations and large banks issue commercial paperas a method of short-term funding in debt markets. Repos are issued primarily by banks andfunded by corporations and other banks through loans in which treasury bills serve ascollateral, with an explicit agreement to pay off the debt (repurchase the treasuries) in thenear future. Fed funds are overnight loans from one bank to another.7.What is the difference between a mortgage and a mortgage-backed security?Mortgagesare loans to households or firms to purchase housing, land, or other real structures,where the structure or land itself serves as collateral for the loans. Mortgage-backed securitiesare bond-like debt instruments that are backed by a bundle of individual mortgages, whoseinterest and principal payments are collectively paid to the holders of the security. In otherwords, when an individual takes out a mortgage, that loan is bundled with other individualmortgages to create a composite debt instrument, which is then sold to investors.8.The U.S. economy borrowed heavily from the British in the nineteenth century to build arailroad system. Why did this make both countries better off?The British gained because they were able to earn higher interest rates as a result of lendingto Americans, while the Americans gained because they now had access to capital to start upprofitable businesses such as railroads.9.A significant number of European banks held large amounts of assets as mortgage-backedsecurities derived from the U.S. housing market, which crashed after 2006. How does thisdemonstrate both a benefit and a cost to the internationalization of financial markets?The international trade of mortgage-backed securities is generally beneficial in that the Europeanbanks that held the mortgages could earn a return on those holdings, while providing neededcapital to U.S. financial markets to support borrowing for new home construction and otherproductive uses. In this sense, both European banks and U.S. borrowers should have benefitted.However, with the sharp decline in the U.S. housing market, default rates on mortgages rosesharply, and the value of the mortgage-backed securities held by European banks fell sharply.Even though the financial crisis began primarily in the United States as a housing downturn, itsignificantly affected European markets; Europe would have been much less affected withoutsuch internationalization of financial markets.

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Mishkin•Instructor’s Manual forTheEconomics of Money, Banking, and Financial Markets, Business School Edition, Fifth Edition6610.How does risk sharing benefit both financial intermediaries and private investors?Financial intermediaries benefit by carrying risk at relatively low transaction costs. Sincehigher risk assets on average earn a higher return, financial intermediaries can earn a profiton a diversifiedportfolio of risky assets. Individual investors benefit by earning returns on apooled collection of assetsissued by financial intermediaries at lower risk. The financialintermediary lowers risk to individual investors through the pooling of assets.11.How can the adverse selection problem explain why you are more likely to make a loan to afamily member than to a stranger?Because you know your family member better than a stranger, you know more about theborrower’s honesty, propensity for risk-taking, and other traits. There is less asymmetricinformation than with a stranger and less likelihood of an adverse selection problem, with theresult that you are more likely to lend to the family member.12.One of the factors contributing to the financial crisis of 2007–2009 was the widespreadissuance of subprime mortgages. How does this demonstrate adverse selection?The issuance of subprime mortgages represents lenders loaning money to the pool ofpotential homeowners who are the highest credit risk and have the lowest net wealth andother financial resources. In other words, this group of borrowers most in need of mortgagecredit was also the highest risk to lenders, a perfect example of adverse selection.13.Why do loan sharks worry less about moral hazard in connection with their borrowers thansome other lenders do?Loan sharks can threaten their borrowers with bodily harm if borrowers take actions thatmight jeopardize their paying off the loan. Hence,borrowers from a loan shark are less likelyto increase moral hazard.14.If you are an employer, what kinds of moral hazard problems might you worry about withregard to your employees?They might not work hard enough while you are not looking or may steal or commit fraud.15.If there were no asymmetry in the information that a borrower and a lender had, could amoral hazard problem still exist?Yes, because even if you know that a borrower is taking actions that might jeopardize payingoff the loan, you must still stop the borrower from doing so. Because that may be costly, youmay not spend the time and effort to reduce moral hazard, and so the problem of moralhazard still exists.

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Mishkin•Instructor’s Manual forTheEconomics of Money, Banking, and Financial Markets, Business School Edition, Fifth Edition6716.“In a world without information costs and transaction costs, financial intermediaries wouldnot exist.” Is this statement true, false, or uncertain? Explain your answer.True. If there are no informational or transactions costs, people could make loans to eachother at no cost and would thus have no need for financial intermediaries.17.Why might you be willing to make a loan to your neighbor by putting funds in a savingsaccount earning a 5% interest rate at the bank and having the bank lend her the funds at a10% interest rate, rather than lend her the funds yourself?Because the costs of making the loan to your neighbor are high (legal fees, fees for a creditcheck, andso on), you will probably not be able earn 5% on the loan after your expenseseven though it hasa 10% interest rate. You are better off depositing your savings with afinancial intermediary and earning5% interest. In addition, you are likely to bear less risk bydepositing your savings at the bank rather than lending them to your neighbor.18.How do conflicts of interest make the asymmetric information problem worse?Potentially competing interests may lead an individual or firm to conceal information ordisseminate misleading information. Asubstantial reduction in the quality of information infinancial markets increases asymmetric information problems and prevents financialmarkets from channeling funds into the most productive investment opportunities.Consequently, the financial markets and the economy become less efficient. That is, falseinformation as a result of a conflict of interest can lead to a more inefficient allocation ofcapital than just asymmetric information alone.19.How can the provision of several types of financial services by one firm be both beneficialand problematic?Financial firms that provide multiple types of financial services can be more efficient througheconomies of scope, that is, by lowering the cost of information production. However, thiscan be problematic since it can also lead to conflicts of interest, in which the financial firmprovides false or misleading information to protect its own interests. This can lead to aworsening of the asymmetric information problem, making financial markets less efficient.20.If you were going to get a loan to purchase a new car, which financial intermediary wouldyou use: a credit union, a pension fund, or an investment bank?You would likely use a credit union if you were a member, since their primary business isconsumer loans. In some cases,it is possible to borrow directly from pension funds, but itcan come with high borrowing costs and tax implications. Investment banks do not provideloans to the general public.

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Mishkin•Instructor’s Manual forTheEconomics of Money, Banking, and Financial Markets, Business School Edition, Fifth Edition6821.Why would a life insurance company be concerned about the financial stability of majorcorporations or the health of the housing market?Most life insurance companies hold large amounts of corporate bonds and mortgage assets,thus poor corporate profits or a downturn in the housing market can significantly adverselyimpact the value of asset holdings of insurance companies.22.In 2008, as a financial crisis began to unfold in the United States, the FDIC raised the limiton insured losses to bank depositors from $100,000 per account to $250,000 per account.How would this help stabilize the financial system?During the financial panic, regulators were concerned that depositors worried their bankswould fail, and that depositors (especially with accounts over $100,000) would pull moneyfrom banks, leaving cash-starved banks with even less cash to satisfy customer demands andday-to-day operations. Thiscould create a contagious bank panic in which otherwise healthybanks would fail. Raising the insurancelimit would reassure depositors that their money wassafe in banks and prevent a bank panic, helping to stabilize the financial system.23.Financial regulation is similar, but not exactly the same, in industrialized countries. Discusswhy it might be desirable—or undesirable—to have the same financial regulation acrossindustrialized countries.This is a topic for which there is no clear answer. On one side, it would be beneficial to havefinancial regulations that are identical in all countries to avoid financial markets participantsto migrate their business to countries with fewer regulations. On the other side, all countriesare different and designing a common set of financial regulations seems to be a ratherdifficult task. Most countries would want to maintain at least part of their regulations, soconsensus is difficult to reach.ANSWERS TO APPLIED PROBLEMS24.Suppose you have just inherited $10,000 and are considering the following options forinvesting the money to maximize your return:Option 1: Put the money in an interest-bearing checking account that earns 2%. The FDICinsures the account against bank failure.Option 2: Invest the money in a corporate bond with a stated return of 5%, although there isa 10% chance the company could go bankrupt.Option 3: Loan the money to one of your friend’s roommates, Mike, at an agreed-uponinterest rate of 8%, even though you believe there is a 7% chance that Mike will leave townwithout repaying you.Option 4:Hold the money in cash and earn zero return.

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Mishkin•Instructor’s Manual forTheEconomics of Money, Banking, and Financial Markets, Business School Edition, Fifth Edition69a.If you are risk-neutral (i.e., neither seek out nor shy away from risk), which of the fouroptions should you choose to maximize your expected return? (Hint:To calculate theexpected returnof an outcome, multiply the probability that an event will occur by theoutcome of that event.)b.Suppose Option 3 and Option 4 are your only choices. If you could pay your friend $100to find out extra information about Mike that would indicate with certainty whether hewill leave town without paying, would you pay the $100? What does this say about thevalue of better information regarding risk?a.With Option 1, since deposits are insured it can be assumed a riskless investment.Thus, the expected total payoff would be $10,000×1.02 = $10,200. With Option 2,a bond return of 5% implies a potential payoff of $10,000×1.05 = $10,500, andthere is a 90% chance that this outcome will occur, thus the expected payoff is$10,500×0.9 = $9450. Under Option 3, the expected payoff is $10,000×1.08×0.93= $10,044. Option 4 is riskless, so the expected total payoff is $10,000. Given thesechoices and the assumption that you don’t care about risk, Option 1 is the bestinvestment.b.Option 3 implies the very real possibility of either receiving nothing (if he actuallyleaves town), or $10,800 (if he indeed pays as promised). If you don’t pay Mike, youhave an expected return of $10,044 as shown above. If you paid your friend the $100and learned that Mike would leave without paying, then obviously you wouldn’t loanMike the money, and you would be left with $9900. However, if you paid the friend$100 and learned that Mike would pay, you would have $10,700 (= $10,000×1.08-$100). After paying your friend Mike, but before knowing the true outcome, yourexpected return would be $10,644 ($9900×0.07 + $10,700×0.93). Under Option 3,paying your friend the $100 is definitely worth it because it increases your expectedreturn and in addition dramatically reduces the downside risk that you make a badloan, and increases the certainty of the payoff amount. That is, with asymmetricinformation (not paying your roommate), you have a range of payoffs of $0 to$10,800 versus $9900 to $10,700 without asymmetric information. Thus, paying asmall amount to improve risk assessment under Option 3 can be very beneficial, atask for which financial intermediaries are well suited. Option 4 is riskless, so theexpected total payoff is $10,000. If you are more risk averse, Option 4 is likely thebetter option. However, if you are more risk neutral then paying your roommate the$100 to have a minimum $9900 payment and possibly as much as $10,700 is thebetter scenario.

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Mishkin•Instructor’s Manual forTheEconomics of Money, Banking, and Financial Markets, Business School Edition, Fifth Edition70ANSWERS TO DATA ANALYSIS PROBLEMS1.Go to the St. Louis Federal Reserve FRED database, and find data on federal debt held bythe Federal Reserve (FDHBFRBN), by private investors (FDHBPIN), and by internationaland foreign investors (FDHBFIN). Using these series, calculate the total amount held andthe percentage held in each of the three categories for the most recent quarter available.Repeat for the first quarter of 2000 and compare the results.See table. Since the year 2000, the Fed has increased its share of federal debt held, andforeign investors have significantly increased its share of debt held. This reflects a significantdecline in the share of federal debt held by private investors.2017:Q12000:Q1Held ($bil.)% ShareHeld ($bil.)% ShareFed2859.113.7501.710.5Private Investors11904.857.13182.866.7Foreign Investors6079.329.21085.022.7Total20843.24769.52.Go to the St. Louis Federal Reserve FRED database, and find data on the total assets of allcommercial banks (TLAACBM027SBOG) and the total assets of money market mutual funds(MMMFFAQ027S). Transform the commercial bank assets series to quarterly by adjustingthe Frequency setting to “Quarterly.” Calculate the percent increase in growth of assets foreach series, from January 2000 to the most recent quarter available. Which of the twofinancial intermediaries has experienced the most growth?See table below. Commercial bank assets have increased by 187% from 2000:Q1 to2017:Q1, while money market mutual fund assets have increased also, but by less thancommercial banks during that time, at 57.1%.2017:Q12000:Q1Commercial Banks$16,158.7 Bil.$5,639.9 Bil.Money Market Mutual Funds$2,664.3 Bil.$1,696.1 Bil.

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Mishkin•Instructor’s Manual forTheEconomics of Money, Banking, and Financial Markets, Business School Edition, Fifth Edition71Chapter 3ANSWERS TO QUESTIONS1.Why is simply counting currency an inadequate measure of money?Since a lot of other assets have liquidity properties that are similar to currency but can beused as money to purchase goods and services, not counting them would understate aneconomy’s access to liquidity for transactions purposes. For this reason, counting assets suchas checking deposits or savings accounts more accurately reflects the stock of assets that canbe considered money.2.In prison, cigarettes are sometimes used among inmates as a form of payment. How is itpossible for cigarettes to solve the “double coincidence of wants” problem, even if aprisoner does not smoke?Even if he or she were a nonsmoker, since the prisoner knows that others in the prison willaccept cigarettes as a form of payment, they themselves would be willing to accept cigarettesas a form of payment. So, rather than prisoners having to barter and trade favors, cigarettessatisfy the double coincidence of wants in that both parties to a trade stand ready to use themto “purchase” goods or services.3.Three goods are produced in an economy by three individuals:GoodProducerApplesOrchard OwnerBananasBanana GrowerChocolateChocolatierIf the orchard owner likes only bananas, the banana grower likes only chocolate, and thechocolatier likes only apples, will any trade between these three persons take place in abarter economy? How will introducing money into the economy benefit these threeproducers?Because the orchard owner likes only bananas but the banana grower doesn’t like apples, thebanana grower will not want apples in exchange for his bananas, and they will not trade.Similarly, the chocolatier will not be willing to trade with the banana grower because shedoes not like bananas. The orchard owner will not trade with the chocolatier because hedoesn’t like chocolate. Hence, in a barter economy, trade among these three people may wellnot take place, because in no case is there a double coincidence of wants. However, if moneyis introduced into the economy, the orchard owner can sell his apples to the chocolatier andthen use the money to buy bananas from the banana grower.Similarly, the banana grower canuse the money he receives from the orchard owner to buy chocolatefrom the chocolatier, andthe chocolatier can use the money to buy apples from the orchard owner. The result is thatthe need for a double coincidence of wants is eliminated, and everyone is better off becauseall three producers are now able to eat what they like best.

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Mishkin•Instructor’s Manual forTheEconomics of Money, Banking, and Financial Markets, Business School Edition, Fifth Edition724.Why did cavemen not need money?Cavemen did not need money. In their primitive economy, they did not specialize inproducing one type of good and they had little need to trade with other cavemen.5.Most of the time it is quite difficult to separate the three functions of money. Money performsits three functions at all times, but sometimes we can stress one in particular. For each of thefollowing situations, identify which function of money is emphasized.a.Brooke accepts money in exchange for performing her daily tasks at her office, since sheknows she can use that money to buy goods and services.This situation illustrates the medium-of-exchange function of money. We often do notthink why we accept money in exchange for hours spent working, as we are soaccustomed to using money. The medium-of-exchange function of money refers to itsability to facilitate trades (hours worked for money and then money for groceries) in asociety.b.Tim wants to calculate the relative value of oranges and apples, and therefore checks theprice per pound of each of these goods as quoted in currency units.In this case,we observe money performing its unit-of-account function. If modernsocieties did not use money as a unit of account, then the price of apples would have tobe quoted in terms of all the other items in the market. This quickly becomes animpossible task. Suppose that a pound of apples sells for 0.80 pounds of oranges, half agallon of milk, one-third of a pound of meat, 2 razor blades, 1.5 pound of potatoes, etc.c.Maria is currently pregnant. She expects her expenditures to increase in the future anddecides to increase the balance in her savings account.Maria is contemplating the store-of-value function of money. As a medium of exchangeand unit of account, measures of money known as M1 or M2 have no important rivals.With respect to the store-of-value function, however, there are many assets that canpreserve value better than a checking account. Maria’s choice to preserve the purchasingpower of her income by increasing her savings account balance is fine for a small periodof time. For a period of 20 years, however, you might choose to buy a U.S. Treasurybond that matures in 20 years (as many grandparents have done as a way to pay for theirgrandchildren’s educations).6.In Brazil, a country that underwent a rapid inflation before 1994, many transactions wereconducted in dollars rather than in reals, the domestic currency. Why?Because of the rapid inflation in Brazil, the domestic currency, the real, was a poor store ofvalue. Thus,many people preferred to hold dollars, which were a better store of value, andused them in their daily shopping.

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Mishkin•Instructor’s Manual forTheEconomics of Money, Banking, and Financial Markets, Business School Edition, Fifth Edition737.Was money a better store of value in the United States in the 1950s than in the 1970s? Whyor why not? In which period would you have been more willing to hold money?Because money was losing value at a slower rate (the inflation rate was lower) in the 1950sthan in the 1970s, it was a better store of value then, and you would have been willing to holdmore of it.8.Why have some economists described money during a hyperinflation as a “hot potato” thatis quickly passed from one person to another?Money loses its value at an extremely rapid rate in hyperinflation, so you want to hold it foras short a time as possible. Thus money is like a hot potato that is quickly passed from oneperson to another.9.Why were people in the United States in the nineteenth century sometimes willing to be paidby check rather than with gold, even though they knew there was a possibility that the checkmight bounce?Because a check was so much easier to transport than gold, people would frequently rather bepaid bycheck even if there was a possibility that the check might bounce. In other words, thelower transactionscosts involved in handling checks made people more willing to acceptthem.10.In ancient Greece, why was gold a more likely candidate for use as money than wine?Wine is more difficult to transport than gold and is also more perishable. Gold is thus a betterstore of value than wine and also leads to lower transactions cost. It is therefore a bettercandidate for use as money.11.If you use an online payment system such as PayPal to purchase goods or services on theInternet, does this affect the M1 money supply, the M2 money supply, both, or neither?Explain.Neither. Although PayPal and many other e-money systems work as other forms of moneydo to facilitate purchases of goods and services, it does not count in the M1 or M2 moneysupplies. Because PayPal and similar payment systems are generally credit-based, thisrequires payment at a future date for funds used today; those future payments must be madeusing existing money that is already in the system, such as currency or funds in a bankdeposit account. In other words, the M1 and M2 money supplies would theoretically remainthe same, but money would move from your checking account to a third party, once thecredit transaction is settled.

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Mishkin•Instructor’s Manual forTheEconomics of Money, Banking, and Financial Markets, Business School Edition, Fifth Edition7412.Rank the following assets from most liquid to least liquid:a.Checking account depositsb.Housesc.Currencyd.Automobilese.Savings depositsf.Common stockThe ranking from most liquid to least liquid is (c), (a), (e), (f), (d), and (b).13.Which of the Federal Reserve’s measures of the monetary aggregates—M1 or M2—iscomposed of the most liquid assets? Which is the larger measure?M1 contains the most liquid assets. M2 is the largest measure.14.It is not unusual to find a business that displays a sign saying “no personal checks, please.”On the basis of this observation, comment on the relative degree of liquidity of a checkingaccount versus currency.The degree of liquidity of an asset is measured by considering how much time and effort(i.e., transaction costs) are needed to convert that asset into currency. Currency is bydefinition the most liquid type of money. Different types of money have different degrees ofliquidity. A check, whichrepresents a balance on a checking account, is a quite liquid type ofmoney. After all, all that is neededto pay for a good or service using a check is the twominutes it takes to include the date and amount and sign the check. However, the aboveexample shows that some merchants refuse to accept checks as a means of payment. (Theycannot refuse to accept dollars, as dollars are legal tender in the United States.) This canresult in significant transaction costs in trying to find a bank or an ATM. It is even possiblethat the transaction never takes place. This example illustrates the point that even inside thesame monetary aggregate, different types of money do not have the same degree of liquidity.15.For each of the following assets, indicate which of the monetary aggregates (M1 and M2)includes them:a.Currencyb.Money market mutual fundsc.Small-denomination time depositsd.Checkable depositsa.M1 and M2b.M2c.M2d.M1 and M2

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Mishkin•Instructor’s Manual forTheEconomics of Money, Banking, and Financial Markets, Business School Edition, Fifth Edition7516.Assume that you are interested in earning some return on the idle balances you usually keepin your checking account and decide to buy some money market mutual funds shares bywriting a check. Comment on the effect of your action (with everything else the same) on M1and M2.Your actions will reduce your checking account balance and increase your holdings ofmoney market mutual fund shares. Considering this transaction only, M1 will decrease asone of its components decreased. M2 will remain constant, as M2 is composed of all itemsthat add up to M1 plus some other types of money that are not so liquid to be considered partof M1. One of these categories is money market mutual fund shares. The decrease in yourchecking account balance is offset by the increase in money market mutual fund shares, andtherefore M2 remains constant.17.In April 2009, the growth rate of M1 fell to 6.1%, while the growth rate of M2 rose to 10.3%.In September 2013, the year-over-year growth rate of the M1 money supply was 6.5%, whilethe growth rate of the M2 money supply was about 8.3%. How should Federal Reservepolicymakers interpret these changes in the growth rates of M1 and M2?During the period in question, the M1 growth rate fell by 0.4%, while the M2 growth rateincreased by 2.0%. Because these growth rates moved in opposite directions, it is difficult tojudge the appropriateness of monetary policy by just looking at the money supply measuresalone. One measure indicates that monetary policy is more expansionary, while the otherindicates the opposite.18.Suppose a researcher discovers that a measure of the total amount of debt in the U.S.economy over the past twenty years was a better predictor of inflation and the business cyclethan M1 or M2. Does this discovery mean that we should define money as equal to the totalamount of debt in the economy?Not necessarily. Although the total amount of debt has predicted inflation and the businesscycle better than M1 or M2, it may not be a better predictor in the future. Without sometheoretical reason for believing that the total amount of debt will continue to predict well inthe future, we may not want to define money as the total amount of debt.

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Mishkin•Instructor’s Manual forTheEconomics of Money, Banking, and Financial Markets, Business School Edition, Fifth Edition76ANSWERS TO APPLIED PROBLEMSQ.19The table below shows hypothetical values, in billions of dollars, of different forms ofmoney.a.Use the table to calculate the M1 and M2 money supplies for each year, as well as thegrowth rates of the M1 and M2 money supplies from the previous year.b.Why are the growth rates of M1 and M2 so different? Explain.2018201920202021A.Currency900920925931B.Money market mutual fund shares680681679688C.Saving account deposits5,5005,7805,9686,105D.Money market deposit accounts1,2141,2451,2741,329E.Demand and checkable deposits1,000972980993F.Small denomination time deposits8308611,1231,566G.Traveler’s checks4432H.3-month treasury bills1,9862,3742,4362,50219.The M1 money supply is the sum of rows A, E, and G for each year. The M2 money supplyisthe sum of all components A–G for each year. Note that 3-month treasury bills are notconsidered part of the M1 or M2 money supply, even though they are fairly liquid assets. Thetable below shows the M1 and M2 money supplies, along with the growth rates from theprevious year. Note that while the M1 money supply is relatively flat (and slightly negativefor 2019), the M2 money supply grows at a much higher, positive rate. This is because thecomponents of M2 are rising much more rapidly compared to the components of M1 (whichare also included in M2). In particular, small denomination time deposits increase 30% from2019 to 2020, and 39% from 2020 to 2021, driving much of the growth in M2. Moreover, thenarrower componentsthatmake up just the M1 money supply represent less than 20%(1904/10128) of the broader M2 indicators. Thus,movements in the money market, savingsaccount, and time deposit measures will have a much bigger impact on M2 growth than thenarrower M1 components will.2018201920202021A.Currency900920925931B.Money market mutual fundshares680681679688C.Saving account deposits5,5005,7805,9686,105

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Mishkin•Instructor’s Manual forTheEconomics of Money, Banking, and Financial Markets, Business School Edition, Fifth Edition77D.Money market deposit accounts1,2141,2451,2741,329E.Demand and checkable deposits1,000972980993F.Small denomination timedeposits8308611,1231,566G.Traveler’s checks4432H.3-month treasury bills1,9862,3742,4362,502Total M1 money stock1904189619081926Total M2 money stock10128104631095211614M1 growth rate−0.40.60.9M2 growth rate3.34.76ANSWERS TO DATA ANALYSIS PROBLEMS1.Go to the St. Louis Federal Reserve FRED database, and find data on currency (CURRSL),traveler’s checks (TVCKSSL),demand deposits (DEMDEPSL), and other checkable deposits(OCDSL). Calculate the M1 money supply and calculate the percentage change in M1 and ineach of the four components of M1 from the most recent month of data available to the sametime one year prior. Which component has the highest growth rate? The lowest growth rate?Repeat the calculations using the data from January 2000 to the most recent month of dataavailable and compare your results.See tables below, showing calculations from the May 2017 benchmark period. Over the oneyear period from May 2016 to May 2017, demand deposits grew the fastest at 9.1%, whiletraveler’s checks grew the least, shrinking by 12.5% over the period. A similar result holdsover the longer period from May 2017 to January 2000; use of traveler’s checks experienceda substantial decline of 75.3%, while demand deposits increased by 323.1%.May 2017May 2016January 2000Currency$1468.5 Bil.$1375.4 Bil.$524.9 Bil.Traveler’s Checks$2.1 Bil.$2.4 Bil.$8.5 Bil.Demand Deposits$1465.2 Bil.%1342.8 Bil.$346.3 Bil.Other Checkable Deposits$569.8 Bil.$525.3 Bil.$242.4 Bil.M1$3505.6 Bil.$3245.9 Bil.$1122.1 Bil.

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Mishkin•Instructor’s Manual forTheEconomics of Money, Banking, and Financial Markets, Business School Edition, Fifth Edition78May 2016 to May 2017January 2000 to May 2017Currency6.8%179.8%Traveler’s Checks−12.5%−75.3%Demand Deposits9.1%323.1%Other Checkable Deposits8.5%135.1%M18.0%212.4%2.Go to the St. Louis Federal Reserve FRED database, and find data on small-denominationtime deposits (STDSL), savings deposits and money market deposit accounts (SAVINGSL),and retail money market funds (RMFSL). Calculate the percentage change of each of thesethree components of M2 (not included in M1) from the most recent month of data available tothe same time one year prior. Which component has the highest growth rate? The lowestgrowth rate? Repeat the calculations using the data from January 2000 to the most recentmonth of data available and compare your results. Use your answers from question 1 todetermine which grew faster: the non-M1 components of M2 or the M1 money supply.See tables below, showing calculations from the May 2017 benchmark period. Over the oneyear period from May 2016 to May 2017, savings deposits grew the fastest at 6.6%, whilesmall time deposits grew the least, decreasing by 9.5% over the period. A similar result holdsfor the period January 2000 to May 2017; savings deposits grew a substantial amount, at414.6% over the period, while small time deposits decreased significantly, by 63.8%.Overall, the M1 money supply grew more over the one-year period (8.0% versus 5.2%) andthe longer period 212.4% versus 183.9%) than the non-M1 components that make up M2;however,the non-M1 components of M2 are much larger in size than the M1 components, sowill have a larger influence overall on the M2 money supply.May 2017May 2016January 2000Small Time Deposits$349.0 Bil.$385.7 Bil.$963.4 Bil.Savings/MMDA$8962.0 Bil.$8405.9 Bil.$1741.6 Bil.Retail MMMF$679.4 Bil.$704.8 Bil.$814.4 Bil.Non-M1 M2$9990.4 Bil.$9496.4 Bil.$3519.4 Bil.M1$3505.6 Bil.$3245.8 Bil.$1122.2 Bil.

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Mishkin•Instructor’s Manual forTheEconomics of Money, Banking, and Financial Markets, Business School Edition, Fifth Edition79May 2016 to May 2017January 2000 to May 2017Small Time Deposits−9.5%−63.8%Savings/MMDA6.6%414.6%Retail MMMF−3.6%−16.6%Non-M1 M25.2%183.9%M18.0%212.4%

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Mishkin•Instructor’s Manual forTheEconomics of Money, Banking, and Financial Markets, Business School Edition, Fifth Edition80Chapter 4ANSWERS TO QUESTIONS1.Would a dollar tomorrow be worth more to you today when the interest rate is 20% or whenit is 10%?It would be worth1/(1+0.20)=$0.83 when the interest rate is 20%, rather than 1/(1+0.10)=$0.91 when the interest rate is 10%. Thus, a dollar tomorrow is worth less with a higherinterest rate today.2.Explain which information you would need to take into consideration when deciding toreceive $5,000 today or $5,500 one year from today.When comparing amounts of money that are disbursed at different dates, one has to take intoconsideration the concept of present value of money. To calculate the present value of the$5,500 promised one year from today one needs to know the annual interest rate. In this case,for an interest rate larger than 10%, one would prefer to accept the $5,000 today (since onecan deposit that amount and receive more than $5,500 one year from today).3.To help pay for college, you have just taken out a $1,000 government loan that makes youpay $126 per year for 25 years. However, you don’t have to start making these paymentsuntil you graduate from college two years from now. Why is the yield to maturity necessarilyless than 12%? (This is the yield to maturity on a normal $1,000 fixed-payment loan onwhich you pay $126 per year for 25 years.)If the interest rate were 12%, the present discounted value of the payments on thegovernment loan are necessarily less than the $1,000 loan amount because they do not startfor two years. Thus,the yield to maturity must be lower than 12% in order for the presentdiscounted value of these payments to add up to $1,000.4.Do bondholders fare better when the yield to maturity increases or when it decreases? Why?When the yield to maturity increases, this represents a decrease in the price of the bond. Ifthe bondholder were to sell the bond at a lower price, the capital gains would be smaller(capital losses larger),and therefore,the bondholder would be worse off.

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Mishkin•Instructor’s Manual forTheEconomics of Money, Banking, and Financial Markets, Business School Edition, Fifth Edition815.Suppose today you buy a coupon bond that you plan to sell one year later. Which part of therate of return formulation incorporates future changes into the bond?Note: Check Equations 7 and 8 in this chapter.The rate of capital gain is the part of the rate of return formula that incorporates futurechanges in the price of the bond. The other part of the formula, the current yield, is composedof the coupon payment (completely determined by the bond´s face value and coupon rate)and the price you paid for the bond today. The rate of capital gain incorporates the futureprice of the bond and is therefore the part of the formula that reflects the consequences offuture price changes.6.If mortgage rates rise from 5% to 10%,but the expected rate of increase in housing pricesrises from 2% to 9%, are people more or less likely to buy houses?People are more likely to buy houses because the real interest rate when purchasing a househas fallen from 3% (=5–2%) to 1% (=10–9%). Therealcost of financing the house is thuslower, even thoughnominalmortgage rates have risen. (If the tax deductibility of interestpayments is allowed for, then it becomes even more likely that people will buy houses.)7.When is the current yield a good approximation of the yield to maturity?The current yield will be a good approximation to the yield to maturity whenever the bondprice is very close to par or when the maturity of the bond is over about ten years. This isbecause cash flows farther in the future have such small present discounted values that thevalue of a long-term coupon bond is close to a perpetuity with the same coupon rate.8.Why would a government choose to issue a perpetuity, which requires payments forever,instead of a terminal loan, such as a fixed-payment loan, discount bond, or coupon bond?The near-term costs to maintaining a given size loan are much smaller for a perpetuity than fora similarfixed payment loan, discount, or coupon bond. For instance, assuming a 5% interestrate over 10 years,on a $1000 loan, a perpetuity costs $50 a year (or $500 in payments over10 years). For a fixed payment loan, this would be $129.50 per year (or $1295 in paymentsover the same 10-year period). For a discount loan, this loan would require a lump sumpayment of $1628.89 in 10 years. For a coupon bond, assuming the same $50 couponpayment as the perpetuity implies a $1000 face value. Thus, for the coupon bond, the totalpayments at the end of 10 years will be $1500.9.Under what conditions will a discount bond have a negative nominal interest rate? Is itpossible for a coupon bond or a perpetuity to have a negative nominal interest rate?Whenever the current pricePis greater than face valueFof a discount bond, the yield tomaturity willbe negative. It is possible for a coupon bond to have a negative nominal interestrate, as long as the coupon payment and face value are low relative to the current price. As anexample, with a one-year coupon bond, the yield to maturity is given asi=(C+F–P)/P; in

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Mishkin•Instructor’s Manual forTheEconomics of Money, Banking, and Financial Markets, Business School Edition, Fifth Edition82this case wheneverC+F<P,iwill be negative. It is impossible for a perpetuity to have anegative nominal interest rate, since this would require either the coupon payment or theprice to be negative.10.True or False: With a discount bond, the return on the bond is equal to the rate of capitalgain.True. The return on a bond is the current yieldiCplus the rate of capital gain, g. A discountbond, bydefinition, has no coupon payments, thus the current yield is always zero (thecoupon payment of zerodivided by current price) for a discount bond.11.If interest rates decline, which would you rather be holding, long-term bonds or short-termbonds? Why? Which type of bond has the greater interest-rate risk?You would rather be holding long-term bonds because their price would increase more thanthe price of the short-term bonds, giving them a higher return. Longer-term bonds are moresusceptible to higher price fluctuations than shorter-term bonds, and hence have greaterinterest-rate risk.12.Interest rates were lower in the mid-1980s than in the late 1970s, yet many economists havecommented that real interest rates were actually much higher in the mid-1980s than in thelate 1970s. Does this make sense? Do you think that these economists are right?The economists are right. They reason that nominal interest rates were below expected ratesof inflation in the late 1970s, making real interest rates negative. The expected inflation rate,however, fell much faster than nominal interest rates in the mid-1980s, so nominal interestrates were above the expected inflation rate and real rates became positive.13.Retired persons often have much of their wealth placed in savings accounts and otherinterest-bearing investments and complain whenever interest rates are low. Do they have avalid complaint?While it would appear to them that their wealth is declining as nominal interest rates fall, aslong as expected inflation falls at the same rate as nominal interest rates, their real return onsavings accountswill be unaffected. However, in practice, expected inflation as reflected bythe cost of living for seniorsand retired persons often is much higher than standard measuresof inflation, thus low nominal rates can adversely affect the wealth of senior citizens andretired persons.

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Mishkin•Instructor’s Manual forTheEconomics of Money, Banking, and Financial Markets, Business School Edition, Fifth Edition83ANSWERS TO APPLIED PROBLEMS14.If the interest rate is 10%, what is the present value of a security that pays you $1,100 nextyear, $1,210 the year after, and $1,331 the year after that?$1,100/(1+0.10)+$1,210/(1+0.10)2+$1,331/(1+0.10)3=$3,000.15.Calculate the present value of a $1,000 discount bond with five years to maturity if the yieldto maturity is 6%PV=FV/(1+i)n, whereFV=1000,i=0.06,n=5. Thus,PV=747.26.16.A lottery claims its grand prize is $10 million, payable over 5 years at $2,000,000 per year. Ifthe first payment is made immediately, what is this grand prize really worth? Use an interestrate of 6%.In present value terms, the lottery prize is worth $2,000,000+$2,000,000/(1.06)+$2,000,000/(1.06)2+$2,000,000/(1.06)3+$2,000,000/(1.06)4, or $8,930,211.17.Suppose that a commercial bank wants to buy Treasury bills. These instruments pay $5,000 inone year and are currently selling for $5,012. What is the yield to maturity of these bonds? Isthis a typical situation? Why?The yield to maturity of these bonds solves the following equation: 5,000/(1+i) = 5,012.After some algebra, the yield to maturity happens to be around–0.24%. This is not a typicalsituation. In normal times,banks will not choose to pay more than the face value of a discountbond, since that implies negative yields to maturity. This example illustrates situations as theones described in the Global Box in this chapter.18.What is the yield to maturity on a simple loan for $1 million that requires a repayment of $2million in five years’ time?14.9%, derived as follows: The present value of the $2 million payment five years fromnow is $2/(1+i)5million, which equals the $1 million loan. Thus 1=2/(1+i)5. Solving fori,(1+i)5=2, so that5210.14914.9%.i=−==19.Which $1,000 bond has the higher yield to maturity, a twenty-year bond selling for $800 witha current yield of 15% or a one-year bond selling for $800 with a current yield of 5%?If the one-year bond did not have a coupon payment, its yield to maturity would be ($1,000–$800)/ $800=$200/$800=0.25, or 25%. Because it does have a coupon payment, its yieldto maturity mustbe greater than 25%. However, because the current yield is a goodapproximation of the yield to maturityfor a twenty-year bond, we know that the yield tomaturity on this bond is approximately 15%. Therefore, the one-year bond has a higher yieldto maturity.

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Mishkin•Instructor’s Manual forTheEconomics of Money, Banking, and Financial Markets, Business School Edition, Fifth Edition8420.Consider a bond with a 4% annual coupon and a face value of $1,000. Complete thefollowing table. What relationships do you observe between years to maturity, yield tomaturity, and the current price?Years to MaturityYield to MaturityCurrent Price22%24%34%52%56%Years to MaturityYield to MaturityCurrent Price22%1038.8324%1000.0034%1000.0052%1094.2756%915.7521.Consider a coupon bond that has a $1,000 par value and a coupon rate of 10%. The bond iscurrently selling for $1,044.89 and has two years to maturity. What is the bond’s yield tomaturity?When yield to maturity is above the coupon rate, the bond’s current price is below its facevalue. The opposite holds true when yield to maturity is below the coupon rate. For a givenmaturity, the bond’s current price falls as yield to maturity rises. For a given yield tomaturity, a bond’s value rises as its maturity increases. When yield to maturity equals thecoupon rate, a bond’s current price equals its face value regardless of years to maturity.22.What is the price of a perpetuity that has a coupon of $50 per year and a yield to maturity of2.5%? If the yield to maturity doubles, what will happen to the perpetuity’s price?$1044.89=$100/(1+i)+$100/(1+i)2+$1,000/(1+i)2. Solving forigives a yield tomaturity of 0.075, or 7.5%.

Economics of Money, Banking and Financial Markets, The, Business School Edition, 5th Edition Solution Manual - Page 31 preview image

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Mishkin•Instructor’s Manual forTheEconomics of Money, Banking, and Financial Markets, Business School Edition, Fifth Edition8523.Property taxes in a particular district are 4% of the purchase price of a home every year. Ifyou just purchased a $250,000 home, what is the present value of all the future property taxpayments? Assume that the house remains worth $250,000 forever, property tax rates neverchange, and a 6% interest rate is used for discounting.The price would be $50/0.025=$2000. If the yield to maturity doubles to 5%, the pricewould fall to half its previous value, to $1000=$50/0.05.24.A $1000-face-value bond has a 10% coupon rate, its current price is $960, and its price isexpected to increase to $980 next year. Calculate the current yield, the expected rate ofcapital gain, and the expected rate of return.The taxes on the $250,000 home are $250,0000.04=$10,000 per year. ThePVof allfuture payments=$10,000/0.06=$166,666.67 (a perpetuity).25.Suppose that you want to take out a loan and that your local bank wants to charge you anannual real interest rate equal to 3%. Assuming that the annualized expected rate of inflationover the life of the bond is 1%, determine the nominal interest rate that the bank will chargeyou. What happens if, over the life of the loan, actual inflation is 0.5%?The bank will charge you a nominal interest rate equal to 1% + 3% = 4%. However, if actualinflation turns out to be lower than expected, then you will be worse off than originallyplanned, since the real cost of borrowing (measured by the real interest rate) turned out to be4–0.5% = 3.5%.

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