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Department of Economics Professor O’Brien Lehigh University Spring 2011 Brief Answers to Eco 29 Problem Sets (Note: These are brief answers. You will probably want to write longer answers to exam questions in order to make sure that your answers are clear and complete.) Problem Set 2 1. More likely. Better to borrow money at 10 percent to buy an asset whose value is increasing 9 percent per year, than to borrow money at 5 percent to buy an asset whose value is increasing only 2 percent per year. 2. Because these railroad bonds were very long-term they were subject to a great deal of interest-rate risk. A portfolio dominated by these bonds was, therefore, high risk. 3. People will sell bonds, forcing their prices down and their interest rates up. 4. If more investors were willing to purchase these bonds as a result of Milken’s arguments, then their liquidity would have increased. 5. The demand for medium-quality corporate bonds will rise, increasing their prices, and reducing their yields. The demand for U.S. Treasury bonds will fall, decreasing their prices, and increasing their yields. 6. The coupon on the state bond will not be subject to tax, so its pre-tax yield will also be 8%. The \$75 coupon on the federal perpetuity will be subject to a tax of \$26.25. If its after- tax yield is 8%, its price must be \$48.75/0.08 = \$609.38. Therefore, its pre-tax yield must be \$75/\$609.38 = 12.31%. 7. Municipal bonds are not subject to the federal income tax, U.S. Treasury bonds are subject to the federal income tax. On a diagram with the price of bonds on the vertical axis, the demand curve for municipal bonds will shift to the right, causing the prices of these bonds to rise and their yields to decline. The demand curve for U.S. Treasury bonds will shift to the left, causing the prices of these bonds to fall and their yields to rise. 8.

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