Reference no: EM131842079
Assignemnt
I. Term structure of interest rates
Suppose that the economy has discount bonds (discussed in question 6) with one- and two-year maturities. Let it1 be the interest rate on a one-year bond issued at the start of year t, and it+11 the interest rate on a one-year bond issued at the start of year t + 1. Let it2 be the interest rate (per year) on a two-year bond issued at the start of year t. We can think of it1 as the current short-term interest rate and it2 as the current long-term interest rate.
a. Assume that, at the start of year t, everyone knows not only it1 and it2, but also the next year's one-year rate, it+11. What must be the relation of to it2 and it1 and it+11? Explain the answer by considering the incentives of lenders and borrowers.
b. If it+11 > it1 what is the relation between it2, the long-term interest rate, and it1, the short-term interest rate? The answer is an important result about the term structure of interest rates.
c. How would the results change if we assumed, more realistically, that there was uncertainty in year t about the future one-rear interest rate, it+11?
II. Financial intermediaries
Consider a financial intermediary, such as a bank, that participates in the credit market. This intermediary borrows from some households and lends to others. (The loan from a customer to a bank often takes the form of a deposit account.)
a. Does the existence of intermediaries affect the result that the aggregate amount of loans is zero?
b. What interest rates would the intermediary charge to its borrowers and pay to its lenders? Why must there be some spread between these two rates?
c. Can you provide some reasons to explain why intermediaries might be useful?
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