If interest rates decline, which would you rather be holding, long- term bonds o

Question

If interest rates decline, which would you rather be holding, long- term bonds or short-term bonds? Why? Which type of bond has the greater interest-rate risk? Interest rates were lower in the mid-1980s than in the late 1970s, yet many economists have commented that real interest rates were actually much higher in the mid-1980s than in the late 1970s. Does this make sense? Do you think that these economists are right? From the Fed article- I thought inflation was we want 2% inflation? "bad" if so why do This DB is worth 10 points. there is a rubric associated with this for 20 points.

Explanation / Answer

1. If interest rates are falling you should be holding long term bonds rather than short term bonds.

Longer term bonds have higher duration than short term bonds. So in case of falling interest rate bond price of longer term bonds will rise more than that of short term bonds.

Please note that interest rate and bond prices are inversely proportional.

2. There is a difference between nominal interest rate and real interest rate.

Nominal Interest rate= Real interest rate+Inflation

So it might be the case that inflation is higher in 1970's than in 1980's and this though real interest rate is lower but total nominal interest rate is higher in 1970's.

So yes the economist do make sense.

3. Considering inflation there are 3 stages

1. Good staedy inflation(in this case 2%)

2. Deflation(negative inflation)

3. Hyper inflation (very high inflation)

If we say that inflation is bad which means we want deflation. In deflation prices of the goods are falling. Due to this people expect that prices now will fall further. This reduces demand of the goods. The reduction in demand causes company to reduce inventory of the goods which reduces employment and GDP(Gross domestic product).

Thus in order to keep demand, employment and thus GDP growing FED wants a small 2% inflation in economy.

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