Without thinking too hard, answer questions i and ii. Then use these to answer a

Question

Without thinking too hard, answer questions i and ii. Then use these to answer a - c.

i) How much would you pay today for a promised payment of $1000 to be received in one year. Give your answer in dollars, and assume the payment is risk-free.

ii. Would your answer to (i) change if the inflation rate today were 6 percent per year? That

is, how many dollars would you pay for $1000 in one year if the rate of inflation was 6%.

a. Now interpret the deals in (a) and (b) as discount bonds. What are their face values? What

prices are you willing to pay? Calculate the nominal and real interest rates for both bonds.

b. Do your answers to parts (a) and (b) verify the Fisher relatio

nship? Explain how or how not.

c. How does an increase in expected inflation affect bond prices? How about a decrease?

Explanation / Answer

A 900 because present value of future 1000 is less than 1000

B 870

C face values of 1000 each. Willing to pay only 900 and 870 respectively. Nominaland real interest rate is 10% in first case WHILEAS it is 10-6=4% in second case

D yes because as real interest rate =nominal interest rate minus inflation

E it reduces value of bond and bond prices fall. In case of decrease bond prices rise

D

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