Describe the effect of the interest rate on money demand and bond demand. Explain

What is the relation between the price of the bond and the interest rate?

 

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1) An economy produces three goods: cars, computers and oranges. Quantity and unitary prices for the years 2002 – 2003 are the following:

Goods Quantity Price Quantity Price
Cars 10 $2000 12 $4000
Computers 4 $1000 6 $500
Oranges 1000 $1 1000 $1

 

a) Construct real GDP for years 2002 and 2003 by using the average price for each good over the 2 years.

b) By what percentage does the real GDP change from 2002 to 2003?

c) What is the GDP deflator in 2002 and 2003? What is the rate of inflator from 2002 to 2003 using the GDP deflator?

 

2) Suppose that a person’s wealth is $50,000 and that his yearly income is $60,000. Also suppose his money demand function is given by: Md = $Y (.30 – i), where Md = money demand, Y = income, and i = interest

a) What is his demand for money and his demand for bonds when the interest rate is 5%?10%?

b) Describe the effect of the interest rate on money demand and bond demand. Explain.

c) Suppose that the interest rate is 10%. In percentage terms, what happens to her demand for money if his yearly income is reduced by 50%?

d) Suppose the interest rate is 5%. In percentage terms, what happens to his demand for money if his yearly income is reduced by 50%?

e) Summarize the effect of income on money demand. How does it depend on the interest rate?

 

3) A bond promises to pay $100 in one year.

a) What is the interest rate on the bond if its price today is $70? $80? $90?

b) What is the relation between the price of the bond and the interest rate?

c) If the interest rate is 6%, what is the price of the bond today?

 

4) Suppose money demand is given by: Md = $Y (.25 – i), where $Y = $100. Also suppose that the supply of money is $20. Assume equilibrium in financial markets.

a) What is the interest rate?

b) If Bank of Canada wants to set it at 15%, at what level should it set the supply of money?

 

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