When interpreting bond prices as present values, discuss what ...

[aabwk4]

When interpreting bond prices as present values, discuss what factors determine the price of a two-year discount bond. Include in your answer an explanation of how changes in each of these factors affects the price of a two-year discount bond.
 
  What will be an ideal response?

Question 2

Use the money market to answer this question. Suppose there is a reduction in income. First, briefly explain what effect this will have on the interest rate. Second, explain all types of policies the central bank could implement to prevent this reduction in income from affecting the interest rate.
 
  What will be an ideal response?

[mcni194]

Answer to Question 1

The price of the two-year bond will be a function of the face value, the current one-year rate and the future expected one-year rate. An increase in either of the one-year rates will reduce the present value of the bond and, therefore, reduce its price. An increase in the face value (constant) would increase the price.

Answer to Question 2

The reduction in income will cause a reduction in money demand, a leftward shift in the money demand curve, and a reduction in the interest rate. To prevent the drop in the interest rate, the central bank could pursue an open market sale of securities (to reduce the money supply) or it could increase the required reserve ratio (which would also reduce the money supply).

[aabwk4]

Excellent

[kswal303]

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