Question

Explain why each of the following statements is True, False, or Uncertain according to economic principles. Use diagrams where appropriate. Unsupported answers will receive no marks. It is the explanation that is important.

A6-5. Suppose a $1000 bond pays annual “coupon interest” equal to 10% and matures in two years. If the yield on bonds with similar risk characteristics is 3%, the price of this bond today is greater than $1000.

A6-6. Suppose the Bank of Canada (BOC) buys $10B worth of bonds from the Canadian banking system that operates with a desired reserve ratio of 5%. Immediately after the transaction, the balance sheet of the BOC expands by $10B, while balance sheet of the banking system is the same size, but in the long run, the balance sheet of both the BOC and the banking system expand by $200B.

A6-7. In the long-run, the money supply is neutral with respect to (does not affect) real GDP.

A6-8. A given increase in the money supply is more effective at shifting the aggregate demand curve the more interest rate responsive (elastic) is the money demand curve.

Answer 1

5) True. This is because the interest rate gained on bond i.e. 10% is greater than the interest rate of 3%. Thus, for the bond to have equal value after two years, the value of the bond with 3% yield at present date should be more than $1000

6). Uncertain. No one can be sure of the market conditions in the future and thus a balance of $200B for both the BOC and Canadian Banking System is uncertain.

7). False. This is because certain factors like wages and prices are sticky and thus do not adjust rapidly in the short run. Thus, money supply cannot be neutral in the short run.

8). False. Money supply is more effective when the interest rates are less responsive to the money demand curve. An extreme example could be that when the LM curve is verticles, then the increase in money supply will have the maximum while if the LM curve is horizontal, then the increase in money supply will have no effect.