CH5: the Behaviour of Interest Rates Flashcards
Pieces of property that serve as a store of value are called
A) assets.
B) units of account.
C) liabilities.
D) borrowings.
A) assets.
Of the four factors that influence asset demand, which factor will cause the demand for all assets to increase when it increases, everything else held constant?
A) wealth
B) expected returns
C) risk
D) liquidity
A) wealth
If wealth increases, the demand for stocks ________ and that of long-term bonds ________, everything else held constant.
A) increases; increases
B) increases; decreases
C) decreases; decreases
D) decreases; increases
A) increases; increases
The relationship between wealth and the demand for stocks and long-term bonds can be explained through the concepts of risk and return. Generally, when wealth increases, people tend to have more disposable income, and they may seek investment opportunities to grow their wealth further.
Demand for Stocks:
Stocks are often considered riskier investments compared to bonds because their value is influenced by market fluctuations. When wealth increases, individuals may have more confidence in taking on risk and may be more inclined to invest in stocks, expecting higher returns. Therefore, the demand for stocks is likely to increase when wealth increases.
Demand for Long-term Bonds:
Long-term bonds are generally considered safer investments than stocks because they provide a fixed interest rate over an extended period. When wealth increases, some individuals may become more risk-averse and prioritize preserving their wealth over seeking higher returns. As a result, the demand for long-term bonds, which are perceived as lower-risk investments, may also increase.
Considering these factors, the correct answer is:
A) increases; increases
This option reflects the typical behavior in financial markets where an increase in wealth often leads to an increased demand for both stocks and long-term bonds, as investors seek a balance between risk and return based on their changing financial circumstances.
Everything else held constant, a decrease in wealth
A) increases the demand for stocks.
B) increases the demand for bonds.
C) reduces the demand for silver.
D) increases the demand for gold.
C) reduces the demand for silver.
An increase in an asset’s expected return relative to that of an alternative asset, holding everything else constant, ________ the quantity demanded of the asset.
A) increases
B) decreases
C) has no effect on
D) erases
A) increases
Here’s the explanation for each option:
A) increases:
If the expected return of an asset increases relative to that of an alternative asset, investors are more likely to be attracted to the higher expected returns. This would lead to an increase in the quantity demanded for the asset.
B) decreases:
This option is not consistent with the idea that an increase in expected return usually leads to an increase in demand. If the expected return is higher, investors are generally more interested in the asset, not less.
C) has no effect on:
This is unlikely to be correct. An increase in expected return, especially when compared to an alternative asset, typically influences investors to prefer the asset with the higher expected return, resulting in an increase in demand.
D) erases:
This is also unlikely. If there is an increase in an asset’s expected return relative to an alternative, it wouldn’t erase the impact; instead, it would likely enhance the appeal of the asset and increase demand.
Everything else held constant, if the expected return on Disney stock rises from 5 to 10 percent and the expected return on CBS stock is unchanged, then the expected return of holding CBS stock ________ relative to Disney stock and the demand for CBS stock ________.
A) rises; rises
B) rises; falls
C) falls; rises
D) falls; falls
D) falls; falls
Let’s break down the problem step by step:
Expected Return on Disney Stock:
The problem states that the expected return on Disney stock rises from 5 to 10 percent. This means that, all else being equal, the expected return on Disney stock has increased.
Expected Return on CBS Stock:
The expected return on CBS stock is unchanged. This implies that there is no change in the expected return on CBS stock; it remains the same.
Now, let’s consider the relative expected returns and the impact on the demand for CBS stock:
Relative Expected Returns:
Since the expected return on Disney stock has increased while the expected return on CBS stock is unchanged, the relative expected return of holding CBS stock has decreased compared to holding Disney stock.
Demand for CBS Stock:
Generally, investors prefer higher expected returns. In this case, the increase in the expected return on Disney stock makes it more attractive compared to CBS stock, which has an unchanged expected return. Therefore, the demand for CBS stock is likely to fall.
Everything else held constant, if the expected return on U.S. Treasury bonds falls from 10 to 5 percent and the expected return on GE stock rises from 7 to 8 percent, then the expected return of holding GE stock ________ relative to U.S. Treasury bonds and the demand for GE stock ________.
A) rises; rises
B) rises; falls
C) falls; rises
D) falls; falls
A) rises; rises
If housing prices are expected to increase, then, other things equal, the demand for houses will ________ and that of Treasury bills will ________.
A) increase; increase
B) increase; decrease
C) decrease; decrease
D) decrease; increase
B) increase; decrease
The expectation of a rise in the house prices will impact the Treasury bill’s demand as its demand will decline and the investors will sell the treasury bills which is held as an investment to purchase the house.
If stock prices are expected to drop dramatically, then, other things equal, the demand for stocks will ________ and that of Treasury bills will ________.
A) increase; increase
B) increase; decrease
C) decrease; decrease
D) decrease; increase
D) decrease; increase
If stock prices are expected to drop dramatically, the stockholders will sell their holdings and then reinvest the capital in less risky financial instruments such as Treasury bills. Hence, we can say that the demand for stocks will decrease and that of Treasury bills will increase.
Everything else held constant, if the expected return on RST stock declines from 12 to 9 percent and the expected return on XYZ stock declines from 8 to 7 percent, then the expected return of holding RST stock ________ relative to XYZ stock and demand for XYZ stock ________.
A) rises; rises
B) rises; falls
C) falls; rises
D) falls; falls
C) falls; rises
We can see that the expected return on RST stock has a decline of 3% (12% - 9%), and the expected return on XYZ stock has a decline of 1% (8% - 7%). As a result, the demand for XYZ stock will increase because though there is a decline in the return, it is not as much as the decline in the RST stock’s expected return. As a result, the expected return of holding RST stock will fall as compared to XYZ stock.
Everything else held constant, if the expected return on U.S. Treasury bonds falls from 8 to 7 percent and the expected return on corporate bonds falls from 10 to 8 percent, then the expected return of corporate bonds ________ relative to U.S. Treasury bonds and the demand for corporate bonds ________.
A) rises; rises
B) rises; falls
C) falls; rises
D) falls; falls
D) falls; falls
Expected Return on U.S. Treasury Bonds:
The expected return on U.S. Treasury bonds falls from 8 to 7 percent. This means that, all else being equal, the expected return on U.S. Treasury bonds has decreased.
Expected Return on Corporate Bonds:
The expected return on corporate bonds falls from 10 to 8 percent. Similar to U.S. Treasury bonds, the expected return on corporate bonds has also decreased.
An increase in the expected rate of inflation will ________ the expected return on bonds relative to that on ________ assets, everything else held constant.
A) reduce; financial
B) reduce; real
C) raise; financial
D) raise; real
B) reduce; real
Expected Return on Bonds:
When there is an increase in the expected rate of inflation, the real (inflation-adjusted) return on fixed-rate bonds tends to decrease. This is because the nominal interest rate on bonds includes compensation for both the real return and expected inflation. If inflation is expected to be higher, the real return (return adjusted for inflation) on bonds decreases.
Relative to Financial or Real Assets:
“Real assets” typically refer to assets like real estate, commodities, or other tangible assets, while “financial assets” encompass a broader category, including stocks, bonds, and other paper assets.
If fluctuations in interest rates become smaller, then, other things equal, the demand for stocks ________ and the demand for long-term bonds ________.
A) increases; increases
B) increases; decreases
C) decreases; decreases
D) decreases; increases
D) decreases; increases
Stocks: When interest rates are on the rise, the value of stocks tends to fall. This is because investors can earn a higher return by investing in bonds, which are considered to be a safer investment. As a result, investors will demand fewer stocks, and the price of stocks will fall. Conversely, when interest rates are falling, the value of stocks tends to rise. This is because investors are now more likely to demand stocks, as they offer a higher potential return than bonds. As a result, the price of stocks will rise.
Bonds: When interest rates are on the rise, the value of bonds tends to fall. This is because investors can now purchase new bonds with a higher interest rate, which will make their existing bonds less valuable. As a result, investors will demand fewer bonds, and the price of bonds will fall. Conversely, when interest rates are falling, the value of bonds tends to rise. This is because investors are now less likely to demand new bonds, as they will have a lower interest rate. As a result, the price of bonds will rise.
If the price of gold becomes less volatile, then, other things equal, the demand for stocks will ________ and the demand for antiques will ________.
A) increase; increase
B) increase; decrease
C) decrease; decrease
D) decrease; increase
C) decrease; decrease
When the price of gold becomes less volatile, it means that its price fluctuations become smaller. This makes gold a less risky investment, as investors can be more confident that its value will not fall significantly.
Stocks are considered to be riskier investments than gold, so when gold becomes less volatile, investors will be less likely to demand stocks as a substitute for gold.
Antiques, on the other hand, are considered to be collectibles that are in limited supply. When gold becomes less volatile, investors will be less likely to demand antiques as a safe haven investment instead of gold. This will decrease the demand for antiques and drive down their prices.
If brokerage commissions on bond sales decrease, then, other things equal, the demand for bonds will ________ and the demand for real estate will ________.
A) increase; increase
B) increase; decrease
C) decrease; decrease
D) decrease; increase
B) increase; decrease
