4. Draw a hypothetical demand and supply curve for S&P 500 stocks and explain briefly the...

4. Draw a hypothetical demand and supply curve for S&P 500 stocks and explain briefly the effects of unexpected inflation caused by a sudden rise in energy prices.

5. Draw a demand and supply curve of loanable funds markets and explain the effects on equilibrium prices and quantities of LF in response to the same situation described in Q4.

Expert Solution

Question 4

The impact of inflation on stock markets is a debatable topic. Empirical research shows that:

Price of growth stocks (that don't pay interim dividends) are by and large unaffected by the unexpected inflation
Price of value stocks (that pay interim dividend) are adversely impacted by the unexpected inflation

S&P 500 stocks are inclusive of both growth and value stocks. Hence, I am plotting the demand supply curve as per following rule:

Unexpected inflation will increase the discount rate used for valuing the stocks. Hence stock prices fall. Demand for stocks decreases. And demand curve shifts inward towards the origin. Please see the position of new demand curve D₁ in comparison to the original demand curve D₀. On the other hand supply of the stocks will increase and the supply curve will shift outward, away from the origin. Please see the location of new supply curve S₁ in comparison to the original supply curve S₀. So the new equilibrium point is E₁against the original equilibrium point of E₀.

The overall impact will be : Reduction in stock prices and increase in discount rate / risk free rate / interest rate.

Question 5

Loanable funds market behaviour will be similar to the behaviour of bond markets. Interest rates and inflation rates are correlated in an economy.

When inflation increases, lenders demand higher compensation for parting away from their money. So demand for loan will decrease. Loans will become less valuable or say interest rate will rise. The demand curve shift inward towards the origin. Please see the position of new demand curve D₁ in comparison to the original demand curve D₀. On the other hand supply of the loans will increase and the supply curve will shift outward, away from the origin. Please see the location of new supply curve S₁ in comparison to the original supply curve S₀. So the new equilibrium point is E₁ against the original equilibrium point of E₀. Please note that behaviour is similar to what has been shown for the stocks above. I am attaching the same graph again.

The overall impact will be : Reduction in bond prices and increase in interest rate.

Rahul Sunny answered 2 years ago

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