Financial markets, expectations and limitations for monetary policy

Question 1

Present discounted value

Answer 1

• the present value of expected, discounted payment flows in the future
• discount factor
• discount rate, e.g. the 1-year nominal interest rate
• the higher the interest rate, the lower the present value of a payment in the future

Question 2

Formula to compute the PV

Answer 2

nominal and real uncertain payment flows
- PV depends positively on payment flows and negatively on the level of interest rates

Question 3

Application: bonds

Answer 3

important for the interest rate of a bond: maturity, default risk (abstracted for simplicity)

Question 4

arbitrage and the yield curve

Answer 4

• expectations hypothesis: investors only care about the expected return
• price for the n-year bond equals the PV of the expected price of a one-year bond purchased in period n-1

Question 5

Interpretation of the empirical yield curve

Answer 5

• upward sloping yield curve: financial markets expect higher short-term interest rates
• downward sloping yield curve: financial markets expect lower short-term interest rates (indicator for recessions)
• but: long-term interest rates also include liquidity- and risk-premia

changes in these premia over time constrain what one can learn from the yield curve about interest-rate expectations

Question 6

Application: the yield curve and monetary policy

Answer 6

forward guidance: influence the yield curve by guiding interest-rate expectations
quantitative easing as an unorthodox monetary policy option: zero lower bounds for short-term interest rate; reduce the interest of long-term bonds (given imperfect arbitrage)

Question 7

quantitative easing in the IS-LM model

Answer 7

• “perfect trap”: liquidity trap, fiscal policy not effective in IS-LM model
• the role of quantitative easing as an unorthodox monetary policy option

Question 8

Stock prices: fundamental value and speculative bubbles

Answer 8

• the fundamental value of Q of a stock is the PV of future dividend payments D

stock price:
- increases if expected dividends are higher
- decreases if interest rates are higher (today and in the future)
- decreases if the risk premium is higher

efficient-market hypothesis: stock prices cannot be predicted systematically (random walk)

• rational speculative bubbles: based on expectations of price increases
• possible that things (possibly without much fundamental value such as tulip bulbs) realize big capital gains through price increases

Question 9

Application: expansionary monetary policy and stock prices

Answer 9

stock prices increase if monetary policy not anticipated
stock prices unchanged if monetary policy anticipated