Final Exam Part 3

The Expectations Hypothesis states that long-term interest rates are determined by the market's expectations of future short-term interest rates. A downward-sloping yield curve suggests that investors expect future short-term interest rates to fall. This is because when short-term rates are expected to decrease, investors are willing to lock in higher long-term rates now, resulting in a downward-sloping yield curve.

According to the liquidity premium theory, the yield curve should be upward sloping and relatively flat when interest rates are expected to remain unchanged over the next few years but there is a risk premium for longer-term bonds. This means that the yields on longer-term bonds will be slightly higher than shorter-term bonds, but the overall slope of the yield curve will not be very steep. This is because investors require a higher return for holding longer-term bonds due to the risk premium, but the expectation of unchanged interest rates keeps the curve from being too steep.

The current euro per $ exchange rate can be calculated by dividing the amount of euros obtained (115 euros) by the amount of dollars spent ($100). This gives a rate of 1.15 euros per dollar.

According to the Liquidity Premium Theory, an inverted yield curve suggests that investors expect an economic slowdown. This is because in a normal yield curve, longer-term bonds have higher yields compared to shorter-term bonds, reflecting the expectation of higher interest rates in the future. However, in an inverted yield curve, shorter-term bonds have higher yields than longer-term bonds, indicating that investors are willing to accept lower yields in the short term due to their pessimistic outlook on the economy. Therefore, the correct interpretation is that investors expect an economic slowdown.

The dollar price of the Japanese automobile can be calculated by dividing the price in yen by the nominal exchange rate. In this case, the price in yen is 2,500,000 yen and the nominal exchange rate is 110 yen/$U.S. Therefore, the dollar price of the Japanese automobile is 2,500,000 yen / 110 yen/$U.S. = $22,727.

An expected appreciation of the dollar would mean that the value of the dollar is expected to increase in the future. This would make the dollar more desirable and valuable, leading to an increase in the demand for dollars. People would want to hold more dollars in anticipation of its appreciation. Therefore, the correct answer is that the demand for dollars would increase.

An inverted yield curve is a valuable forecasting tool because it seldom occurs and when it does, it can signal an economic slowdown. This means that when the yield curve is inverted, with short-term interest rates higher than long-term interest rates, it suggests that investors are expecting lower economic growth in the future. This is because they are demanding higher returns for short-term investments, indicating a lack of confidence in the economy. Therefore, an inverted yield curve can be seen as a warning sign of an upcoming economic downturn.

The real exchange rate determines whether a U.S. dollar will buy more in the U.S. or in a foreign country. The real exchange rate takes into account the nominal exchange rate and adjusts it for inflation differences between the two countries. If the real exchange rate is higher in the foreign country, then a U.S. dollar will buy more there. Conversely, if the real exchange rate is higher in the U.S., then a U.S. dollar will buy more in the U.S. The nominal exchange rate alone is not sufficient to determine the purchasing power of a U.S. dollar in a foreign country.

An appreciation of the real exchange rate means that the value of the U.S. currency increases relative to foreign currencies. This makes U.S. exports more expensive to foreigners because it takes more foreign currency to purchase the same amount of U.S. goods. As a result, foreign consumers may be less likely to buy U.S. exports, leading to a decrease in export sales.

When the dollar will purchase more euros, it means that the exchange rate between the two currencies has changed in favor of the dollar. This implies that foreign goods will become relatively less expensive compared to American goods. This is because with more euros, one can buy more foreign goods for the same amount of dollars. Therefore, the correct answer is that foreign goods become relatively less expensive than American goods.

If inflation in the United States averages more than inflation in Europe over a long period of time, we should expect the dollar to depreciate relative to the euro. This is because higher inflation in the United States would erode the purchasing power of the dollar, making it less valuable compared to the euro. As a result, the exchange rate between the two currencies would shift in favor of the euro, causing the dollar to depreciate.

According to the given answer, differences in inflation rates between countries will create changes in exchange rates. This means that if one country has a higher inflation rate compared to another country, the currency of the country with higher inflation will depreciate in value relative to the currency of the country with lower inflation. This is because higher inflation erodes the purchasing power of a currency, making it less desirable in the foreign exchange market. As a result, the exchange rate between the two countries will adjust to reflect the difference in inflation rates.

High transportation costs can explain why concrete likely does not follow the law of one price. The high costs of transporting concrete from one location to another can result in different prices in different regions. This is because the transportation expenses add to the overall cost of the product, making it more expensive in areas that are farther away from the source of production. As a result, the price of concrete can vary significantly depending on the transportation distance, leading to a deviation from the law of one price.

To purchase goods and services produced abroad, individuals or businesses need to supply dollars on the foreign exchange market in order to exchange their currency for the foreign currency required for the transaction. This allows them to make international purchases and engage in international trade.

The given information states that the yield on a 30-year U.S. Treasury security is higher (6.5%) than the yield on a 2-year U.S. Treasury bond (4.0%). This indicates that the longer-term bond has a higher yield, which suggests that the yield curve is upward sloping. In an upward sloping yield curve, longer-term bonds have higher yields compared to shorter-term bonds.

The Liquidity Premium Theory suggests that investors require a higher yield for longer-term bonds to compensate for the additional risk and uncertainty associated with holding them. In this case, if the one-year bond is expected to yield 6% next year, it implies that the two-year bond will have a higher yield to reflect the increased risk of holding it for an additional year. Therefore, the yield today on a two-year bond will be more than 5%.

If U.S. assets are perceived as riskier compared to foreign assets in the foreign exchange market, investors may want to sell their U.S. assets and buy foreign assets instead. This would lead to an increase in the supply of dollars in the market, as more people are selling their dollars.

The correct answer is that a proposed increase in the federal income tax rate should have no impact on the slope of the yield curve since the tax laws impact all maturities the same. This means that regardless of the length of time until the maturity of a bond, the increase in the tax rate would affect all bonds equally. Therefore, there would be no change in the relative yields between short-term and long-term bonds, resulting in no impact on the slope of the yield curve.

An increase in the real interest rate on U.S. bonds would make holding U.S. dollars more attractive for foreign investors. This is because higher interest rates offer higher returns on investments. As a result, the demand for dollars will increase as more investors seek to acquire U.S. bonds and other dollar-denominated assets. Therefore, the correct answer is that the demand for dollars will increase.

According to the Expectation Hypothesis, if the current one-year interest rate is 4% and the two-year interest rate is 6%, it implies that investors are expecting the future one-year rate to be 8%. This is because the Expectation Hypothesis suggests that long-term interest rates are determined by the market's expectations of future short-term interest rates. In this case, the higher two-year interest rate suggests that investors expect the future one-year rate to be higher than the current one-year rate.

The risk spread on Baa bonds refers to the additional yield that investors demand for holding these bonds compared to U.S. Treasury securities. When economic growth is strong, investors are more optimistic about the economy and therefore demand less compensation for taking on the risk of holding Baa bonds. As a result, the risk spread on Baa bonds tends to decrease, indicating an inverse relationship with economic growth. Conversely, during periods of economic downturn or uncertainty, investors become more risk-averse and demand higher compensation, leading to an increase in the risk spread on Baa bonds.

The yield curve does not show the difference in default risk between securities. Instead, it shows the relationship among bonds with the same risk characteristics but different maturities. The shape of the yield curve can provide insights into market conditions and expectations about interest rates, but it does not directly indicate default risk.

The Expectations Hypothesis suggests that long-term yields are simply the average of current and expected short-term yields. However, it cannot explain why yield curves usually slope upward. This is because an upward-sloping yield curve indicates that long-term yields are higher than short-term yields, which contradicts the hypothesis. The Expectations Hypothesis assumes that investors have no preference for short or long-term bonds, but in reality, investors often demand higher yields for longer-term bonds due to the additional risk and uncertainty associated with them.

According to the liquidity premium theory, if investors become less certain about future monetary policy, they will demand a higher premium for holding longer-term bonds. This increased demand for longer-term bonds will drive down their yields, causing the yield curve to become more upward sloping. This is because longer-term bonds will have lower yields compared to shorter-term bonds, resulting in a steeper yield curve.

The Expectations Hypothesis suggests that the slope of the yield curve depends on the expectations for future short-term rates. This means that if market participants expect short-term interest rates to increase in the future, the yield curve is likely to be upward sloping. Conversely, if market participants expect short-term interest rates to decrease in the future, the yield curve is likely to be downward sloping. The slope of the yield curve reflects the market's expectations and beliefs about future interest rate movements and can be used to gauge investor sentiment and economic outlook.

Short-term bonds being perfect substitutes for long-term bonds means that investors view both types of bonds as equally attractive and are willing to hold either one. This implies that there is no preference or advantage for holding one type of bond over the other. It also suggests that investors do not expect any additional benefits or risks associated with holding long-term bonds compared to short-term bonds. Therefore, the statement supports the idea that short-term bonds can be easily exchanged for long-term bonds without any significant difference in terms of returns or risks.