On the basis of Problem 16-1, imagine that initially the market interest is 5 pe
ID: 1202422 • Letter: O
Question
On the basis of Problem 16-1, imagine that initially the market interest is 5 percent and at this interest rate yon have decided to hold half of your financial wealth as bonds and half as holdings of non-interest-bearing money. You notice that the market interest rate is starting to rise, however, and you become convinced that it will ultimately rise to 10 percent. (See pages 365-367.) In what direction do you expect the value of your bond holdings to go when the interest rate rises? If you wish to prevent the value of your financial wealth from declining in the future, how should you adjust the way you split your wealth between bonds and money? What does this imply about the demand for money?Explanation / Answer
a. There exist inverse relationship between the value of bond and interest rate so when there is increase in the interest rate then value of bond decreases and due to this, bond holdings decreases by the public.
b. In future if there is expectation that interest rate will increase then, people have to spend less proportion of their income in purchasing bonds as value of bonds will decrease in future. People have to spend more proportion of their savings in bank which will provide him more return.
When interest rate increases then demand of money decreases as people prefer to keep their money in banks.
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