Question

True false:

If the Fed lowers the money supply, the price level effect will tend to lower the equilibrium interest rate.

Municipal bonds tend to have lower yields than government bonds of the same maturity.

If a corporate bonds becomes more liquid, its risk premium will fall.

Answer 1

1. False. When the Fed reduces the money supply, the equilibrium interest rate increases. As per the law of supply, the interest rate or the cost of borrowing is higher when the money available to lend is smaller and thus when the money supply decreases, the interest rate tends to increase.

2. True. The income the municipal bonds generate is exempted from federal income taxes, while the income generated by the government bonds are liable for taxation. Thus in order to maintain or to keep the yield at par for both bonds, the yield on the municipal bonds are lower than on government bonds.

3. True. The risk premium or especially the liquidity risk premium is offered on the bonds which are illiquid or which tends to block the money for a long period of time. Since teh money invested cannot be converted to cash to put to use for some other purposes, thus the investors ask for the premium. When the bonds will become more liquid, the risk premium on these thus tends to fall.