5. This part of the assignment is purely conceptual with no com putations requir

Question

5. This part of the assignment is purely conceptual with no com putations required. Explain the following with referencesto the required readings: a. What islikely to happen to interest rates if the rate of inflation suddenly increases? b. Suppose there aretwo bonds each with coupon payments of $50. The first bond pays $1,000 in five years, and the other one pays $1,000 in ten years. If interest rates increased, would the value of the bonds increase or decrease? Which of the two bonds would have their value change more after the increase in interest rates? Explain your reasoning.

Explanation / Answer

a.)

Inflation, by definition, is an increase in the price of goods and services within an economy. It’s caused due to an imbalance in the goods and buyer ratio – when the demand in an economy is higher than the supply, prices go up.

The interest rate is the rate at which interest is paid by borrowers for the use of money that they borrow from creditors.

Lower interest rates means more money available for borrowing, making consumers spend more. The more consumers spend, the more the economy grows, resulting in increase in demand for commodities(goods), while there iss no change in supply. An increase in demand which can’t be met by supply results increase in price i.e. in inflation.
Higher interest rates make people concerned and encourage them to save more and borrow less. As a result, the amount of money circulating in the market reduces. Less money, of course, would mean that consumers find it more difficult to buy goods and services. The demand is less than the supply, the hike in prices stabilise, and sometimes, prices even come down.
In general, as interest rates are lowered, more people are able to borrow more money. The result is that consumers have more money to spend, causing the economy to grow and inflation to increase. The opposite holds true for rising interest rates. As interest rates are increased, consumers tend to have less money to spend. With less spending, the economy slows and inflation decreases.

b.)

Interest rate change will have greater effect on 10 year bond than on 5 year bond.

Think of it as the length of time that your bond will be affected by an interest rate change.

For example, suppose interest rates rise today by 1%. A bond with 5 year duration will have coupon payment left until maturity will be underpaying the investor by 1% for only 5 years. On the other hand, A bond with 10 year duration will have coupon payment left until maturity will be underpaying the investor by 1% for only 10 years. This difference in remaining payments will cause a greater drop in a long-term(10 year) bond's price than it will in a short-term(5 year) bond's price when interest rates rise.

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