3. A month later, Bob buys a $1000 government bond from the Fed with this money.

Question

3. A month later, Bob buys a $1000 government bond from the Fed with this money. A) What happens to the money supply (M1)? Does it increase or decrease? By how much? The money supply decreases by $1000. B) How would this impact Bob's future spending? Would it increase or decrease? Bobs future spending would increase because he will make a profit from the savings bond. C) Under what circumstances would Bob be likely to buy bonds ? (describe the economy, his perceptions) D) 5 years later Bob sells the bond for $1000 and buys $1000 in common stock. Describe the differences in Bob's investment portfolio. (how does it differ; what are the risks; what are his returns)

Explanation / Answer

(A) Since currency is part of M1 but government bond is not, purchase of a bond using $1000 cash will lower M1 by $1000.

(B) Future spending will rise because Bob will earn interest from the government bond (unless it is a zero-coupon bond), which will raise his income.

(C) Bob will buy bond is:

- He perceives that purchasing power of money will fall due to expected higher inflation, or

- Interest on bond will be of a higher dollar amount that will compensate the loss in purchasing power caused by inflation, or

- Bob is a risk-taker who will ignore the possibility that the interest received from bond may be inadequate to cover up the erosion in purchasing power of money.

(D) Buying common stock of same amount will make Bob an equity shareholder of the firm instead of a debt-holder. This will increase his risk because debt is the most secure form of asset; in case of a bankruptcy or liquidation, the firm is obliged to pay back to debt-holders, leaving the residual asset (or cash) available to equity holders only after all debt is repaid. But, if such an event does not occur, he gets a steady income every year from debt interest, while income from equity (dividend) is uncertain and variable. Finally, since equity is riskier, return on equity (dividend) is also higher than the debt interest, resulting in a longer-run appreciation of the stock, leading to higher value of asset portfolio.

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