# Exercise 5 Answers - The demand for bonds will decrease as...

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ECON 423 Class Exercise 5 Bond Market The following schedule gives the demand and supply schedule for a discount bond with a face value of \$10000. Assume that the term to maturity is one year. P F I Bs Bd 9000 10000 0.11111 70 150 9200 10000 0.086957 80 140 9400 10000 0.06383 90 130 9600 10000 0.041667 100 120 9800 10000 0.020408 110 110 9900 10000 0.010101 120 100 9950 10000 0.0005025 130 90 a. If the expected inflation rate in this equilibrium is 1%, what is the real interest rate? Equilibrium nominal rate is 0.020408 Equilibrium real rate is 0.010408 b. If the expected inflation rate rises to 2%, what will happen to the demand and supply of bonds? What will be the new equilibrium price of the bond?
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Unformatted text preview: The demand for bonds will decrease as the real return on bonds will decrease.= Show this as a leftward shift in the demand for bonds. On the other hand, the supply of bonds will increase as the real cost of borrowing is lower Show this as a rightward shift in the supply of bonds This will reduce the price of bonds and the bond (nominal) yield will rise by 1%. The new bond yield will be 0.010408+0.02 = 0.030408 New Bond Equilibrium price = \$1000/1.030408=\$970. There is no information to determine the new equilibrium quantity. Draw the graph below using the above information....
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