The demand curve
will shift to the left, the price falls, and
the equilibrium interest rate will rise.
The Risk and Term Structure of Interest Rates
2. U.S. Treasury bills have lower default risk and more liquid-
ity than negotiable CDs. Consequently, the demand for
Treasury bills is higher, and they have a lower interest rate.
4. True. When bonds of different maturities are close substi-
tutes, a rise in interest rates for one bond causes the interest
rates for others to rise because the expected returns on
bonds of different maturities cannot get too far out of line.
6. (a) The yield to maturity would be 5% for a one-year bond,
6% for a two-year bond, 6.33% for a three-year bond, 6.5%
for a four-year bond, and 6.6% for a five-year bond. (b) The
yield to maturity would be 5% for a one-year bond, 4.5% for
a two-year bond, 4.33% for a three-year bond, 4.25% for a
four-year bond, and 4.2% for a five-year bond. The upward-
sloping yield curve in (a) would be even steeper if people
preferred short-term bonds over long-term bonds, because
long-term bonds would then have a positive liquidity pre-
mium. The downward-sloping yield curve in (b) would be
less steep and might even have a slight positive upward slope
if the long-term bonds have a positive liquidity premium.
8. The flat yield curve at shorter maturities suggests that short-
term interest rates are expected to fall moderately in the near
future, while the steep upward slope of the yield curve at
longer maturities indicates that interest rates further into the
future are expected to rise. Because interest rates and expected
inflation move together, the yield curve suggests that the
market expects inflation to fall moderately in the near future
but to rise later on.
10. The reduction in income tax rates would make the tax-
exempt privilege for municipal bonds less valuable, and they
would be less desirable than taxable Treasury bonds. The
resulting decline in the demand for municipal bonds and
increase in demand for Treasury bonds would raise interest
rates on municipal bonds while causing interest rates on
Treasury bonds to fall.
12. Lower brokerage commissions for corporate bonds would
make them more liquid and thus increase their demand,
which would lower their risk premium.
14. You would raise your predictions of future interest rates,
because the higher long-term rates imply that the average of
the expected future short-term rates is higher.
The Stock Market, the Theory of Rational
Expectations, and the Efficient Market Hypothesis
2. There are two cash flows from stock, periodic dividends and
a future sales price. Dividends are frequently changed when
firm earnings either rise or fall. The future sales price is also
difficult to estimate, since it depends on the dividends that
will be paid at some date even farther in the future. Bond
cash flows also consist of two parts, periodic interest pay-
ments and a final maturity payment. These payments are
established in writing at the time the bonds are issued and