2. a. If the real interest rate is 5% and the (expected) inflation rate is 0%,...

2. a. If the real interest rate is 5% and the (expected) inflation rate is 0%, what will be the price of a risk free bond that matures in one year with a face value of $500?

b. If the (expected inflation rate increases to 2%, what will the price of this bond be?

c. Show this change (from a to b) in a graph of the bond market with the quantity of bonds on the horizontal axis and the price of the bonds on the vertical.

--- I know how to solve A and B. I need to help C. ----

Expert Solution

Bond price is obtained by using nominal interest rate, where

Nominal interest rate = Real interest rate + Inflation rate

When Inflation rate > 0, Nominal interest rate > Real interest rate, and the higher the inflation rate, the higher the nominal rate. So, nominal interest rate is higher in part (b) than in part (a).

When nominal interest rate (prevailing in market) increases (therefore making the bond coupon rate relatively lower), demand for bond falls. Demand curve shifts leftward, decreasing both price and quantity of bonds.

In following graph, (P) and quantity (Q) of bonds are depicted along vertical and horizontal axes. D0 & S0 are initial demand and supply curves intersecting at point A with initial equilibrium price P0 and quantity Q0. When bond demand decreases, D0 shifts left to D1, intersecting S0 at point B with lower bond price P1 and lower quantity of bonds Q1.

Rahul Sunny answered 2 years ago

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