Answer to Question #185443 in Microeconomics for Edward Kamutuva

Question

A bond promises to pay N$150 in one year. 3.1 (a) What is the interest rate on the bond if its price today is N$65? N$75? N$85 (6) (b) What is the relationship between the price of the bond and interest rate? (4) (c) If the interest rate is 15%, what is the price of the bond today (4) 3.2 With a help of diagram explain the effect of an increase in the interest rate on output. (6) 3.3 explain the relationship between money multiplier and reserve ratio; and money multiplier and currency- deposit ratio

Answer 1

a.)

Face value of the bond$=\$150$

Price of bond today$=\$65$

Interest rate on the bond =face value$\div price today -1$

$=\frac {150}{65}-1$

$=130.7\%$

ii. If price today is $75.

$=\frac{150}{75}-1$

$=2-1=1$

$=100\%$

iii. If price of bond today is $85

$=\frac{150}{85}-1$

$=0.764$

$=76.4\%$

b.) If the price of the bond increases ,interest rate decreases. Therefore there is an opposite relationship between price of the bond and the interest rates on them.

c.)If interest rate is 15% ,what is price of bond today?

price of bond$=\frac{ face value of bonds}{ 1+interest rate}$

$=\frac{150}{1+0.15}$

price of bond today$=\$130.4$

2.Effect of an increase in interest rates on output.

Interest rate increases increase the desire to save because the benefit for saving has increased. As a result, saving in the economy is likely to rise, reducing consumption (assuming that people's incomes remain constant). Interest rates rise, which raises the cost of borrowing and, as a result, the cost of investing. As a result, companies are less likely to spend, and investment in the economy falls. Because of the increased cost of borrowing, government debt interest rates will increase, but we can't predict how this will affect government spending. The impact on net exports will be determined by how interest rates in trading partners change. Assuming that they do.

3.Relationship between money multiplier and reserve ratio

Money multiplier$=\frac {1}{reserve ratio}$

There is a negative relationship between money multiplier and reserve ratio. Also as money multiplier decreases ,reserve ratio increases.

The currency deposit ratio depicts the volume of currency held by individuals as a percentage of total deposits. A reduction in the money multiplier is caused by a rise in the cash deposit ratio.