Question

The following table shows the stream of income produced by several different assets. In each case, P, P2, and P3 are the payments made by the asset in Years 1, 2, and 3. For each asset, compute the asset's present value and explain why the market price for each asset will be the asset's present value. (10 marks) Asset Treasury Bill Bond Bond Stock Market Interest Rate) 3% 5% 7% SO $7500 S300 $200 S300 9% $100 S150 2. The following questions refer to the graph below. MS Interest Rate MD Quantity of Money a. Explain (and show in the diagram) why the Bank of Canada cannot independently set the money supply and the interest rate. (Hint: try explaining what would happen if the bank did try holding the money supply where it is and set the interest rate above or below the equilibrium above.) (4 marks) b. Suppose the Bank leaves the money supply unchanged but that the demand for money increases. Show this in the diagram. What happens to interest rates? What happens to investment? (4 marks) c. In the situation of part b, explain why monetary policy has been contractionary even though the Bank of Canada did not change the money supply. (2 marks)

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Answer 1

Answer: 1

Formula for computation of present value =Present Value=Future Value /(1+r) PV of cash flows of Treasury bond=$1500/(1+0.03)+0/(1+0.03)2+0/(1+0.03)3=$1456.3 PV of cash flows of bond=$0/(1+0.05)+0/(1+0.05)2+7500/(1+0.05)3=$6861.84 PV of cash flows of bond=$300/(1+0.07)+300/(1+0.07)+300/(1+0.07)3=$280.37+262.03+244.89 = $787.29 PV of cash flows of bond=$100/(1+0.09)+150/(1+0.09)2+200/(1+0.09)3=$91.74+$126.26+$115.83= $333.83 Assets are usually priced at present value of expected cash flows to be derived out of the asset in future. This will help the investor assess the amount of profit he is going to gain out of buying the asset or take a decision to invest it elsewhere considering various factored like return, time value of money etc. There is no point in valuing an asset more than the benefits going to be derived from the asset hence market value will be present value of the asset's future income.

Answer: 2

a) Bank of Canada cannot independently set the money supply as it is the sum total of money in circulation, total of bank deposit and money created by commercial bank in the particular economy. so, Bank of Canada cannot set it independently and interest rate cannot be set independently as it can be targeted only because bank can either target money supply or interest rate that is also depend upon the money demanded in the economy. if money supply increased then at intersection point with money demanded interest rate will fall and vice versa. b) if money supply is fixed but demand for money increase then interest rate will also increase as supply of money decrease comparing to demand for money only interest rate rise. and investment will decrease as interest rate and investment are inversely related to each other.

The following questions refer to the graph below. Interest Rate — Quantity of Money

c) monetary policy is contractionary in nature even though bank of Canada has not increase money supply, because increase in money demand leads to inflation also that might affect economy adversely, as demand for money leads to high prices of goods and services in the economy. second reason might be investment, as rise in interest rate leads to fall in the investment so it is target to enact the money supply at is existing level otherwise investment will decrease.