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1. For this question, assume that one-year and two-year bonds have the same risk;
therefore, you can ignore risk here. Assuming that there is arbitrage between one-year
bonds and two-year bonds, we know that the expected rate of return on two-year bonds
A) will equal the expected rate of return from holding a one-year bond for one year.
B) will equal the expected rate of return from holding a one-year bond for two years.
C) will be larger than the expected rate of return from holding a one-year bond for one
year.
D) will be smaller than the expected rate of return from holding a one-year bond for
one year.
E) will be exactly half the rate of return on one-year bonds.

2. An upward-sloplng yleld curve suggesLs LhaL flnanclal markeL parLlclpanLs expecL shorL-
Lerm lnLeresL raLes wlll
A) rlse ln Lhe fuLure.
8) fall ln Lhe fuLure.
C) be unsLable ln Lhe fuLure.
u) noL change ln Lhe fuLure.
L) be equal Lo zero ln Lhe fuLure.
3. Suppose pollcy makers lmplemenL a flscal expanslon LhaL ls nC1 fully anLlclpaLed by
flnanclal markeL parLlclpanLs. We know LhaL Lhls wlll
A) always cause sLock prlces Lo fall.
8) always cause sLock prlces Lo rlse.
C) Lend Lo cause sLock prlces Lo rlse lf Lhe LM curve ls very flaL.
u) Lend Lo cause sLock prlces Lo rlse lf Lhe LM curve ls verLlcal.

4. Suppose Lhe currenL one-year lnLeresL raLe ls 4. Also assume LhaL flnanclal markeLs
expecL Lhe one-year lnLeresL raLe nexL year Lo be 3, and expecL Lhe one-year raLe Lo
be 6 Lhe year afLer LhaL. Clven Lhls lnformaLlon, Lhe yleld Lo maLurlLy on a Lhree-year
bond wlll be approxlmaLely
A) 4.
8) 3.
C) 6.
u) 13.

3. Assume LhaL Lhe one-year lnLeresL raLe ls on Lhe verLlcal axls of Lhe lS-LM model and
LhaL Lhe yleld curve ls lnlLlally upward sloplng. Suppose LhaL flnanclal markeL
parLlclpanLs expecL LhaL Lhe cenLral bank wlll pursue a moneLary conLracLlon ln Lhe
fuLure. Clven Lhls lnformaLlon, we would expecL whlch of Lhe followlng Lo occur?
A) Lhe yleld curve wlll become sLeeper
8) Lhe yleld curve wlll become flaLLer
C) Lhe yleld curve wlll become horlzonLal
u) Lhe yleld curve wlll become downward sloplng

6. As Lhe LM curve becomes sLeeper, an unexpecLed decrease ln consumer confldence
A) wlll cause a relaLlvely large lncrease ln ouLpuL and relaLlvely large lncrease ln Lhe
lnLeresL raLe.
8) wlll cause a relaLlvely small lncrease ln ouLpuL and relaLlvely small lncrease ln Lhe
lnLeresL raLe.
C) ls more llkely Lo cause sLock prlces Lo rlse.
u) ls more llkely Lo cause sLock prlces Lo fall.

CuesLlons:

1. uslng Lhe approxlmaLe" formula Lo calculaLe Lhe n-year yleld:
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1haL ls Lhe fuLure expecLed shorL Lerm lnLeresL raLes are expecLed Lo be hlgher Lhan
currenL shorL Lerm lnLeresL raLe
2. Suppose LhaL Lhe annual lnLeresL raLe Lhls year ls 4, and flnanclal markeL parLlclpanLs
expecL Lhe annual lnLeresL raLe Lo lncrease Lo 4.3 nexL year, Lo 6 Lwo years from
now, and Lo 3.3 Lhree years from now. ueLermlne Lhe yleld Lo maLurlLy on each of Lhe
followlng bonds.
a. A one-year bond
b. A Lwo-year bond
c. A Lhree-year bond

3. lf Lhe cenLral bank lmplemenLs a moneLary expanslon ln Lhe currenL perlod and ls noL
expecLed Lo conLlnue Lhls pollcy ln Lhe fuLure. lf Lhe yleld curve ls upward sloplng,
would lL be sLeeper or genLler? Pow would sLock prlces behave?

4. lf lndlvlduals expecL a cuL ln fuLure Laxes.
a. Lxplaln, uslng approprlaLe graphs, whaL effecL Lhls expecLed reducLlon ln
fuLure Laxes wlll have on Lhe yleld curve?
b. lf Lhls evenL of fuLure Laxes cuL has been anLlclpaLed, whaL would happen Lo
sLock prlces ln Lhe currenL perlod? Lxplaln
c. lf Lhls evenL of fuLure Laxes cuL has noL been anLlclpaLed, whaL would happen
Lo sLock prlces ln Lhe currenL perlod? Lxplaln