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Chapter 11 Macro (22 Econ)

Work It Out
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You must read each slide, and complete any questions on the slide, in sequence.
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The yield for a perpetuity bond is determined by the simple formula:

Yield = Interest Payment/Price of Bond

A. The yield on a $1,000 perpetuity bond that pays $40 a year forever to the bondholder is percent.

Correct!
Incorrect!
The yield for a perpetuity bond is determined by the simple formula: Yield = Interest Payment/Price of Bond = $40/$1,000 = 0.04 = 4% For further review see section “Bond Prices and Interest Rates."
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      B. Suppose that actions taken by the Fed cause interest rates in the economy to fall by 2%. How will this affect the price of the bond presented in part (a), that pays $40 per year in interest? The price of the bond would change to $.

      Correct!
      Incorrect!
      First, the new interest rate must be determined. In part (a), the interest rate was calculated to be 4%. A decrease of 2% means that the new interest rate is (4 – 2 =) 2%. We also know from part (a) that the bond pays $40 interest per year forever. Now again use the yield formula to determine the price of the bond. Yield = Interest Payment/Price of Bond
      Price of Bond = Interest Payment//Yield
      2% = 0.02 = $40//Price
      Price of Bond = $40/0.02 = $2,000       In conclusion, the price of the $1,000 perpetuity bond has increased to $2,000 when the interest rate fell from 4% to 2%.
      For further review see section “Bond Prices and Interest Rates."
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          C. Now suppose that one purchases a new $1,000 perpetuity bond at the lower interest rate presented in part (b). The annual interest payment will be equal to $.

          Correct!
          Incorrect!
          Using the yield formula again, we find that at the new interest rate of 2%, interest payments on a $1,000 bond would be $20, found by: 2% = 0.02 = (Interest Payment)/$1,000
          Interest Payment = $1,000 × 0.02 = $20           When the interest rate decreases, so does the interest payment.For further review see section “Bond Prices and Interest Rates."
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              D. If interest rates were to rise back to the original level determined in part (a), how will that affect the price of the new bond purchased in part (c)? The new price will be $.

              Correct!
              Incorrect!
              First recall that in part (a) the yield was calculated to be 4%, and in part (c) the interest payment was calculated to be $20 per year. If a bond that pays $20 per year has a 4% return, then the price of the bond is $500. This is calculated as follows: 4% = 0.04 = $20/Price of Bond
              Price of Bond = $20/0.04 = $500               Therefore, when the interest rate increased, the price of the bond decreased.
              For further review see section “Bond Prices and Interest Rates."
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