Supply and demand diagram of the market structures

1) Draw a supply/demand diagram of the market for “loanable funds” in the U.S. Use the “interest rate” as the “price” of loanable funds on your diagram. Show the effects of a rise in the expected inflation rate on your diagram.

2) Is your result in (1) consistent with the Supply/Demand model of the effects of a rise in inflation expectations on the T-Bill market that I drew in this week’s lecture notes? Explain [Hint: discuss the relationship between a T-Bill’s price and the annual yield (or rate of interest) earned by an investor who buys that T-Bill and holds it until maturity]

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3) Assume that the treasury is currently running large surpluses (tax collections exceed new government spending). On a S/D diagram show the effect on Treasury Bond markets of using these surpluses to buy back outstanding treasury securities and reduce the governments’ outstanding debt.

4) What rate of return (yield to maturity) would be earned by an investor who bought newly issued 1-year T-bills @ a market price of $95 per $100 of face value?

5) Draw a supply/demand diagram to model the US stock market (use the value of a stock price index such as the S&P 500 to represent the overall level of stock prices.) Show the effect on stock prices of a decline in interest rates in the economy. (hint: from the view point of those with accumulated savings to invest, interest bearing financial assets such as money market funds and bank certificates of deposit are substitutes for stock market mutual funds….also, from the viewpoint of future corporate sales, lower interest rates mean that customers can more cheaply finance the purchase of goods)

6) The US treasury isn’t the only issuer of bonds. Corporations also issue bonds that have future payment structures like U.S. Treasuries. Of course, unlike the federal government, corporations can go bankrupt, leaving their bondholders unable to collect all of their scheduled payments. Because of this risk of default, corporate bonds must have a higher yield in equilibrium than similarly structured Treasury bonds. Under what economy-wide economic conditions, if any, might you expect to see corporate bond yields rise while Treasury Bond yields fell?

7. In the same context of Q6 above, briefly explain why the prices of Short Term US treasury securities are still high enough to keep the interest low enough despite the fact that the US Bond rating has been downgraded from AAA status to AA+ by S&P in July, 2012.

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