Sonoma State University
Dr. Robert Eyler
Suggested Answers to Homework #3
Please answer the questions fully and draw graphs or use equations when needed.
all your work and remember that these are practice for the midterm questions, so try your best
It will pay off later.
The financial markets are linked to the macroeconomy in many ways, chiefly through
monetary policy and expectations.
Explain how stock prices may be affected by FED policy briefly.
Stock prices are affected by FED policy because the FED, or any central bank, controls interest
Also, there is the issue of expectations.
The stock price formula we discussed in
class reflects that stock prices move due to two categorical changes.
First is a change in the
expected cash flows from a stock.
If the company is perceived to be more profitable, and may
share those profits in the form of dividends, the expected cash flows (ECF) from the stock may
Further, if the company is more profitable, investors may be willing to pay more for the
stock to take advantage of perceived higher demand in the future for the stock.
This enhances the
expected growth rate of the stock’s price, increasing the price of stock now.
If the central bank
increases the money supply, this can be a signal that stocks in general will rise due to higher
profits as consumer spending rises.
Because of the link between GDP and the wages, salaries and
profits paid, ECF should also rise in general.
Second, as interest rates fall, the expected rate of
return for investors falls due to a drop in the alternative rates of return on riskless securities.
the baseline rate of return for any stock is the rate of return on government debt in the United
States (or any major, industrialized nation), then the central bank lowering interest rates forces
these rates down either directly or indirectly via open market operations for example.
As a result,
would fall and stock prices would rise in general.
Notice that these changes mirror each other
and leave little to no ambiguity.
The reverse is true if the FED increased interest rates.
Explain how bond prices are affected by FED policy, using open market
operations as an example.
Bond prices are affected by central bank policy, specifically open market operations, in a
fundamental way using the time value of money.
When the FED buys government debt on the
open market from banks, they are trying to lower rates of interest.
They do this through
increasing their demand for government debt which has the effect of decreasing the effective rate
of return on government debt.
As a result, banks sell their holding of these securities to the
Federal Reserve, and receive cash.
What the central bank assumes is that the banks will have an
economic incentive to immediately lend out the newly-received cash because other bond prices
will be relatively low versus the riskless government debt.
As the banks increase their supply of